Budget 2013 has produced a few nasty restrictions on income tax reliefs, which cannot be said to be business friendly at all. In a nutshell, certain types of tax deduction will be capped at 25% of an individual’s annual income, or £50,000, whichever is the greater number.
The Draft Guidance sets out a list of the reliefs affected, and examples of how to do the sums. Perhaps the most significant impact will be felt by individuals setting up their own business, whether as a sole trader or in partnership.
- There is to be an annual limit to the amount of tax relief that can be set off against an individual’s income;
- This limit is 25% of total income, or £50,000, whichever is greater;
- The limit applies to the aggregate of all reliefs that the individual is seeking to claim for that particular tax year.
- The limit applies only to income tax reliefs – capital gains reliefs are not affected (for now).
An example of what this actually means
The following are two examples taken from HMRC’s Draft Guidance 1.
“Ben’s total income in 2013-14 is £180,000. He claims relief for trade losses of £70,000 made in 2013-14 against his total income in 2013-14. Ben’s relief limit in 2013-14 is £50,000 as this is the greater of £50,000 and 25 per cent of his income (which is £45,000).”
“Jas’s total income in 2013-14 is £480,000. She claims relief for qualifying loan interest arising in 2013-14 of £125,000. Jas’s relief limit is £120,000 as 25 per cent of her income is greater than £50,000.”
(Qualifying loans include taking out a loan to buy into a business, such as a company or partnership. So in Jas’s example, she may have taken out the loan to buy into a partnership with Ben, giving him the opportunity of offloading his disastrous trading performance onto someone else.)
First note that the losses mentioned are both on the blacklist. These include trade losses and qualifying loan interest.
Second, the limit applies to the aggregate of all reliefs that the individual is attempting to claim. There isn’t a separate limit for each type of tax loss on the blacklist. So if Ben is also a property tycoon with property losses of £20,000, these losses cannot be utlised against his general income – there is only one £50,000 limit and this has already been breached.
Third, note that the losses affected are those that are available to set against an individual’s total, or general income. This doesn’t affect the setting off of business expenses against receipts. We shall look at this principle later – but first we need to see what is on the blacklist.
So what is on the blacklist?
The following are all on the list in HMRC’s Draft Guidance 2. However, I have rearranged the order and grouped certain items together.
There are three types of trade losses affected, all of which can be relieved against general income:
- Sideways relief – which is always available. 3 Losses can be set against income from the current or previous tax year;
- Early trade loss relief – an extension to sideways relief. Any loss made in the first four years of the trade can be set against income in the current year and/or carried back. There is an added bonus in that the carry back can be up to three years 4. This is a particularly useful relief for the early years of a new business;
- Post-cessation trade relief – these are reliefs for payments or events occurring within seven years of the trade permanently ceasing. For example:
- After going bust, the trader may be sued for shoddy work and has to pay a sum of money to put things right; or
- A bad debt owed by an errant customer is finally written off.
It makes sense for these particular deductions to be allowable against general income. Since the trade has come to an end, there isn’t any trading income available to set them against.
These are similar to the reliefs for trading losses and are also available against general income:
- Property loss relief where the loss arises from capital allowances or agricultural expenses 5;
- Post-cessation property relief – for payments or events occurring within seven years of a UK property business coming to an end 6.;
Qualifying Loan Interest – available for interest paid on certain loans, such as a loan to buy into a close company or employee controlled company or partnership 7.
Losses on shares – capital losses incurred in respect of some types of shares, can be set off against general income. This includes shares held in an unquoted trading company, but investments qualifying for the venture capital schemes are not affected by this measure 8;
Employment Loss Relief – available in certain circumstances where losses or liabilities arise from employment 9;
Former Employees Deduction – for liabilities incurred while working in a previous job 10;
Losses on Deeply Discounted Securities – these are losses incurred on certain types of esoteric investment 11 – this isn’t something that most people get involved in, so we shall say no more about this topic.
What isn’t caught
There is a list set out at the end of HMRC’s Draft Guidance 12, which is reproduced below:
- Relief for charitable donations such as Gift Aid, payroll giving, gifts of land and shares and Community Investment Trust Relief;
- Relief under the Business Investment Exemption Scheme for non-domiciles and non-residents 13;
- Annual Payments;
- Foreign and dividend tax credits;
- Terminal trade loss relief;
- Losses arising from furnished holiday lettings;
- Losses arising from miscellaneous transactions 14;
- Reliefs under the venture capital schemes including the Seed Enterprise, Enterprise Investment Scheme and Venture Capital Scheme;
- Pension reliefs;
- Interest payments by a personal representative on a loan taken out to pay inheritance tax.
What does it all mean for those starting their own business?
First of all, the good news. The restrictions are on setting off losses against general income. They do no apply in calculating the taxable profits of the business.
So taking Ben’s example further, suppose that his trading receipts were £20,000 and his expenses amounted to £90,000. These expenses can be set off freely against the receipts to yield the £70,000 loss mentioned in HMRC’s example. It doesn’t matter that the expenses exceed the £50,000 limit – they are not being deducted against general income.
However, the £50,000 limit does apply to the £70,000 loss once it is decided to set this against general income. So £20,000 worth of losses are unused. There are now two options:
- Carry back £20,000 to the previous year. The restrictions still apply as the carry back is only available against general income;
- Carry forward to set against future trading receipts. Since the set off isn’t against general income, the restrictions don’t apply.
Now for the not-so good news.
Suppose you are starting out in business for the first time. You have decided not to leave your safe day job for the present, but plan to do so once you feel confident that your new venture has a chance of succeeding. (We shall assume that you have the time to moonlight – perhaps your day job is only part time).
One doesn’t expect to make huge profits in the early years of a business – in fact, losses are par for the course. The fact that these losses can be set against your salary is a bonus. The alternative is to carry forward the losses against future profits – but when will these profits materialise? Which would you prefer? Getting a tax rebate now, or getting it some time in the future, by which time its value will have been eroded by inflation?
Setting a cap on this “present” tax rebate isn’t very helpful.
For similar reasons it isn’t helpful to cap tax deductions for loan interest, especially when the loan is taken out to buy into a business.
But at least EIS relief is safe
There are no restrictions on tax reliefs available for the various venture capital schemes such as the Enterprise Investment Scheme (“EIS”), including the mini “seed” version. We should be thankful for this lucky escape, but before everyone starts celebrating, here is some food for thought.
Suppose you have decided to start your business, but this time you will operate as a company, with several of your friends and relatives agreeing to invest their hard earned savings. The shares will qualify for EIS, which means tax reliefs for income and capital gains. In particular, if the investment goes bad, your friends will have the consolation that they can claim income tax relief for the loss made on their shares.
This is not affected by the new rules. However, what is the position if, one day you get a letter from your accountant telling you he is very sorry but your company has lost its EIS status. There are so many complicated rules and regulations governing the scheme that is very easy to fall foul of them – and you’ve just had the bad luck to be the latest victim.
The consequences are that the associated tax reliefs are normally withdrawn. However, until recently it was still possible to set a capital loss on the shares against income, because this relief extended to shares in unqoted trading companies, irrespective of whether they were EIS-compliant. It will still possible to claim this relief if something goes wrong, but there is now a cap on the amount that can be claimed.
Your friends are not going to be very happy if this situation arises. The moral is, that even though the venture capital type schemes are not affected, they can easily lose their tax status, together with the associated tax incentives.
The new limits on income tax reliefs are obviously not friendly to taxpayers. In particular the restrictions against claiming for business related losses against general income is hard.
We already have rules to limit the sideways reliefs – these rules were introduced in order to stop tax motivated investments such as film and R&D partnerships. This is a far cry from the situation where a person is starting up his own business for the first time. A country’s economy grows because of these new businesses – they need all the encouragement they can get, especially in times of economic hardship.
- Draft Guidance, paragraph 3.5 ↩
- Draft Guidance, paragraph 4.1 ↩
- ITA 2007 s 64. ↩
- ITA 2007 s 72 ↩
- ITA 2007 s 120 ↩
- ITA 2007 s 125 ↩
- See ITA 2007 s 383(2) for the full list. ↩
- ITA 2007 s 131 – the shares have to be issued by the company, and not purchased “second hand”. ↩
- ITA 2007 s 128. ↩
- ITEPA 2003 s 555. ↩
- ITTOIA 2005 ss 446-448, ss 453-456. ↩
- Draft Guidance, Annex A. ↩
- ITA 2007 s 809VA. ↩
- ITA 2007 s 1016. ↩
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