TAXguide 14/21 Income tax loss carry back

In this TAXguide Rebecca Benneyworth explains the measure in detail and examines some of the complexities that arise when considering the practical implications of the loss carry back.

Overview

The new relief in Sch 2, Finance Act 2021 (FA 2021), which allows a trading loss to be carried back against the previous three years trading profits, is a welcome measure that tends to be wheeled out regularly in times of financial difficulty.

However, a loss relief claim should not be considered in isolation. It may have an impact on other claims and elections and taxes that a taxpayer might be subject to. This TAXguide considers not only the practicalities of making a claim, but highlights the impact this might have on other areas of the taxpayer’s affairs.

1 Relief under Sch 2, FA 2021

The new loss relief provision sits alongside the existing reliefs for trading losses and thus is available in addition to all of the other methods of relief.

Losses arising in the tax years 2020/21 and 2021/22 may be carried back against trading profits of the three preceding years, taking relief in later years first. Although the legislation does not specify that relief is given against profits of the same trade, this is implied by the use of “the” in paras 1(6) and 2(6) of the Schedule. 

The maximum amount which may be offset under these rules is £2m for each fiscal year of loss.

Relief is given at “Step 2” in the calculation of the tax liability for the year as set out in s23, Income Tax Act 2007 (ITA 2007), which means that any provisions which take as income the amount after Step 2 (this is the most common definition of income used for many purposes) will take income after relief is given under this provision. 

Note that where a trader prepares accounts for tax purposes on a cash basis, the only relief available for losses is to carry losses forward and set them against future profits of the same trade. It follows, therefore, that relief under Sch 2, FA 2021 will not be available to those using the cash basis.

1.1 Conditions for relief

Paragraphs 1(1) and 2(1) require that the loss would be eligible for a claim under s64, ITA 2007. This means that the loss meets the conditions for relief in s64, which are stated in ss66 to 70, ITA 2007. So the loss will have to meet the following conditions before relief under Sch 2, FA 2021 is available:

• The trade is commercial (s66, ITA 2007), meaning that it is carried on throughout the basis period in the tax year
  • On a commercial basis, and
  • With a view to profit.
• If the trade is farming or market gardening, it meets the additional requirement that there must not have been a loss (before capital allowances) in each of the previous five tax years, unless there is a reasonable expectation of profit (ss67, 68 and 70, ITA 2007). Note that this check is performed on an actual tax year basis (that is, if necessary by time apportioning periods of account), and not on the basis periods for the tax years concerned.

The question of whether the trade is carried on on a commercial basis and with a view to profit is more likely to be challenged by HMRC in the context of ‘lifestyle’ businesses. One recent case on this topic is Roulette V2 Charters LLP [2019] UKFTT 0537(TC). The First-tier Tribunal considered a wide range of evidence including projections, actual income and costs, the way the business was operated, and the fact that by the time of the periods challenged the partnership had not made a profit at all, which should have caused the members to review the arrangements. For those wishing for a comprehensive overview of case law relating to this area the case decision is a useful read as a significant number of other cases are quoted in the decision.

In addition, para 1(1)(b) and para 2(1)(b), Sch 2, FA 2021 require that either Condition A or Condition B is met:

• Condition A: that the taxpayer has made a claim under s64, ITA 2007 for relief for either or both of the current or preceding tax years, or
• Condition B: the taxpayer must have no relief available – that is no income against which relief can be set under s64 – in the tax year of the loss or the preceding tax year. 

1.2 Giving effect to the relief

The loss is set only against the trading profits of the preceding three years, taking relief in the more recent years first. As noted above the relief is against profits of the same trade. The effect of the claim is that a single claim is made, affecting all three (or possibly two) of the years, taking into account the impact of the requirement for a claim under s64.

Example

Joseph has made a loss in his business for the year ended 31 December 2020. This falls into tax year 2020/21 and therefore the relief under Sch 2, FA 2021 is open to him.

Joseph makes a claim under s64, ITA 2007 to set some of the loss against his other income in 2020/21. This meets Condition A, so the single claim for relief against trading profits under Sch 2, FA 2021 covers the tax years 2019/20, 2018/19 and 2017/18 in that order. Joseph cannot restrict the carry back to two years; once a claim is made it automatically affects all three years, assuming that profits are available, capped at £2m.

Karen has also incurred a loss in her 2020/21 basis period. She decides to claim under s64 to set the loss against her total income of 2019/20. When she makes a claim under Sch 2, FA 2021 that will affect 2018/19 and 2017/18 only (in that order) and capped at £2m as her claim under s64 must have eliminated all of the available income in 2019/20 in order for there to be further losses for which relief is sought.

1.3 General point on claims under s64, ITA 2007

Where a claim is made under s64 there will generally be some losses which are set against income which would be covered by personal allowances in the absence of the claim, and thus s64 can produce quite poor value for money in terms of loss relief. However, as it is a requirement before relief can be claimed under Sch 2, FA 2021, you will need to weigh up the alternatives carefully to decide which claim is preferable.

Example

Lawrence has incurred a trading loss of £18,000 in the basis period for 2020/21. He has interest income of £280 in 2020/21. In 2019/20 he has trading profits of £12,000, dividend income of £6,000 and interest of £2,200. In 2018/19 his trading profits were £20,000, dividends were £6,000 and interest £2,500.

(1) Section 64 claim in 2020/21

The loss would be set against other income of £280, which is not taxable, so no relief is obtained for this part of the loss. However, the remaining loss of £17,720 would then be carried back against trading profits as follows:

2019/20 £12,000
2018/19 £  5,720

(2) Section 64 claim in 2019/20

Claiming under s64 in the preceding year would mean that all of the loss is relieved under s64 in 2019/20, but more of the loss is used against income which would have been covered by the personal allowance, dividend nil rate band or personal savings allowance, so is of limited value. 

The tax saving through loss relief is as follows:

(1) Section 64 relief in 2020/21

(2) Section 64 relief in 2019/20

So in this example, it is much better to claim for relief under s64 in 2020/21 which restricts the offset of losses in earlier years to the trading profits only.

Class 4 NIC

Note that any losses set against non-trading income will produce a carry forward loss for Class 4 purposes only. This can only be relieved at the value shown if the next available profits exceed the Class 4 threshold for the year by at least that amount, as the loss must be set against the first available profits. The additional relief is claimed by making an entry on the Self Employment Full (SA 103F) pages in box 102 on the next return (2021/22 in the example above). Note that you will not be able to claim relief using the Self Employment Short (SA103S) pages, as this box is absent.

1.4 The impact on tax paid

Carry back of losses does not reduce the tax paid in earlier years, but instead creates a stand-alone tax credit in the year of the loss. So the recalculation of the tax liability in the earlier years when relief is given is purely a notional calculation, carried out to arrive at the difference between the tax as per the return filed at the time and the new notional tax liability based on the loss carry-back claim. 

The returns for previous years will not be re-filed with amended figures, as they are unchanged, but the tax credit is reflected in the calculation of the tax for the later year. Formally, in the example above where s64 relief is claimed in 2020/21 the tax calculation would appear as follows:

This amount, together with any payments on account already paid for 2020/21 will be repayable to the taxpayer. Any interest and surcharges imposed on late paid tax in 2018/19 and 2019/20 are unaffected by the claim as the tax due for those years has not been amended.

2 Practical complications – impact on other aspects of the tax position

2.1 Transferable allowances – marriage allowance claims

For married couples and civil partners, the loss and the relief claimed may make a difference to any marriage allowance claims that may or may not have been made already.

First, and most obviously, in the year of the loss, the individual may have surplus allowances resulting from the loss even before any loss relief is claimed, if any other sources of income are modest and total less than the personal allowance. So a transfer to the spouse or civil partner may be appropriate in the year of the loss.

Next, in any year in which relief is given for the loss, this may reduce the income of the claimant to below the personal allowance, and therefore a transfer of allowance to the spouse or civil partner should also be considered for those years.

Finally, in years in which relief is given, the claimant may still have sufficient income to be a taxpayer, but the effect of loss relief may be to reduce their income so that tax is now only due at basic rates (or the Scottish intermediate rate) which would allow a spouse or civil partner with unused allowances to transfer part of their allowances to the claimant. If they have previously been liable at higher or additional rates a transfer of surplus allowances would not have been possible at the time.

Note that the time limits for elections (by the relinquishing party) and claims (by the gaining party) is four years after the end of the tax year.

Example

Matthew and Nicholas have been civil partners for many years. Matthew has run a successful nightclub for many years, normally making profits of around £70,000 a year. Nicholas is a struggling artist, with profits normally running at around £7,500 a year. 

However, when lockdown started in March 2020 their financial affairs were badly hit. Matthew’s nightclub has been closed since the start of lockdown and will not reopen before August 2021. As a result, Nicholas took a job in their local supermarket in April 2020, earning a salary of £22,000. His self-employment generated no profits in 2020/21, but he continues to trade, and is building up a stock of paintings for a forthcoming exhibition. Neither has any other income sources.

Nicholas incurred a loss of £97,000 for the year ended 31 March 2021. He received no Self-Employment Income Support Scheme (SEISS) payments as his previous profits were too high. Nicholas received SEISS payments of £5,125 in total through grants 1 to 3.

2020/21

Matthew has no income at all in 2020/21 so cannot use his personal allowance. Nicholas has income in total of £27,125 and can benefit from the transfer of 10% of Matthew’s personal allowance. Matthew should complete the online election to transfer his surplus allowance to Nicholas for 2020/21, or alternatively can complete the election on his self assessment tax return.

Nicholas is also taxed within self assessment but has no profits other than SEISS to report. His salary was taxed at source, but he will benefit from the additional allowances transferred by Matthew, which can be shown on his tax return, although it is sensible to ensure that Matthew has first made the election to forgo part of his allowance, otherwise the marriage allowance claim will not be actioned, and HMRC will issue an amended tax calculation without the additional allowances.

2019/20 and 2018/19

Before the pandemic, the couple were not in a position to utilise marriage allowance as Matthew was a higher rate taxpayer. If Matthew decides to take the earliest relief possible for his loss in 2020/21 he will claim relief under s64 ITA 2007 in 2019/20, thus meeting condition A for relief under Sch 2, FA 2021. This will reduce his 2019/20 income to nil, so there is no merit in making a marriage allowance transfer as Nicholas also has income of less than his personal allowance. 

However, the balance of the loss (around £27,000) when carried back to 2018/19 will reduce Matthew’s income for that year to £43,000 which is below the higher rate threshold for that year (£46,350). This means that Nicholas can elect to forgo part of his allowances for 2018/19 and give the benefit of this to Matthew. Matthew will benefit from an additional allowance of £1,190 reducing his tax liability by £238.

2.2 Interaction with interest relief for residential lettings

Where a client incurs a trading loss and makes a claim for relief this may disturb relief for interest on residential lettings under s274AA, Income Tax (Trading and Other Income) Act 2005. The maximum relief for interest is given by s274AA(2) as the lower of the relievable amount (the qualifying amount of interest for relief) and the profits for tax purposes of the property business for the year less any brought forward losses (termed the adjusted profits), or if less, the adjusted profits on which the individual is liable to income tax.

Where a loss has reduced the trading income to nil, but there is a residential property income source, together with a related interest charge, it is possible that the taxable amount of the rental income will be zero, and this will disturb interest for which relief has previously been given. The interest will then become unrelieved and is carried forward for relief in a later year.

It is unlikely that this issue would cause a change in the decision as to which loss relief to choose, but this might happen if the rental activity ceased at the same time, potentially leaving interest permanently unrelieved. It might then be preferable to carry the loss forward for relief in later years as otherwise the interest relief will be permanently lost.

Example

Olivia has incurred a trading loss in 2020/21 of £35,000. She has residential property income and incurs interest on a related loan. The amounts are as follows:

2020/21

Olivia elects to claim relief under s64, ITA 2007 in 2020/21 as her rental income in that year is modest as a result of her tenant moving out to return to Poland following Brexit. She had been unable to find another tenant during lockdown but will recommence letting later in 2020/21.

Her interest charge of £5,000 (the full amount) is unrelieved as there is no income remaining in that year after the loss relief claim.

2019/20

Olivia elects under Sch 2, FA 2021 to carry the balance of the loss back three years. The amount of the loss means that relief is given in 2019/20 and 2018/19.

In 2019/20 the loss extinguished the profit of £20,000, leaving rental income of £7,500 liable to tax. However, as this amount is covered by the personal allowance, no relief for the interest is available. So a further £3,750 of interest is unrelieved.

2018/19

There remains a loss of £13,000 to carry back to 2018/19, reducing the trading profits to £12,000. However this means that the rental income is taxable in full, and therefore relief is given for the interest in that year.

Olivia therefore has a total of £8,750 in interest to carry forward as at 5 April 2021.

2.3 Impact on pension annual allowance tax charge

The income definition for both threshold income and adjusted income in the rules tapering the pensions annual allowance starts with the income after Step 2 in s23, ITA 2007. Therefore, if there is a loss carry-back claim under Sch 2, FA 2021 this will reduce the previous year’s income for the purposes of the annual allowance taper, and therefore can potentially reduce the annual allowance charge levied in that earlier year if the taper resulted in excessive contributions.

The effect of this will come out in the notional re-calculation of the tax liability for the year and therefore will be reflected in the tax credit that is calculated. However, there is a significant problem if the taxpayer had elected for the scheme to bear the tax due on the annual allowance charge. There is no clear indication what the impact of this reduction in income would be in this case, and the only saving grace is that cases of this nature are likely to be extremely rare.

2.4 Impact on pension contributions paid in earlier years

Carrying back a loss does not alter the amount of relevant income for the purposes of gaining tax relief on pension contributions, so there is no change to the amount contributions made by the taxpayer that qualify for relief. 

However, if the impact of the loss carried back is to reduce the income and therefore, for example, eliminate any higher rate tax liability, the benefit of the pension contribution would only be the basic rate relief given at source rather than any higher rate relief. This may dilute the value for money gained through the carry back of losses.

2.5 Impact on gift aid payments made in earlier years

The carry back of losses to an earlier year may mean that the tax due for that year is reduced to zero, particularly when a claim is made under s64, ITA 2007. Any gift aid payments made in a year where there is no tax liability may therefore give rise to a tax liability on the gift in order to collect the basic rate relief on the donation. This will again limit the value for money gained through the loss relief claim.

2.6 Impact on high income child benefit charge

A loss relief claim that results in carrying back the loss to an earlier year will reduce the income in that year and may therefore impact the tax charge arising through the high income child benefit charge (HICBC). 

The income for the purpose of HICBC is the ‘adjusted net income’ which is arrived at after deducting loss reliefs – that is it commences with Step 2 in s23, ITA 2007. Where the claimant has been liable to HICBC, recalculating the tax after offsetting the loss will automatically recognise the reduced income for the purposes of the charge, and the saving will become part of the tax credit generated in respect of that year. In these cases, carrying back the loss and reducing or eliminating HICBC will provide extra ‘value for money’ from the loss carried back as relief is obtained at an additional marginal rate.

However, this area is not without additional complexity. This is best demonstrated by an example.

Example

Peter and Rachel have been living together for many years. The couple have no children together, but Tom’s son Sebastian who was 12 in 2021 lived with the family and Tom received child benefit in respect of Sebastian. Unfortunately, due to the pressures of the pandemic, repeated lockdowns and home schooling, the couple separated acrimoniously in July 2021.

Peter made profits and losses in his business as follows: 2019/20 profit of £58,000, 2020/21 loss of £14,000. Peter did not receive and SEISS payments as his profits in the last few years were over £50,000; he received bank interest in 2020/21 of £2. Rachel had an annual salary of £54,000 in both years, taxed under PAYE, and is not required to complete a self assessment return.

2020/21

Peter is likely to make a claim under s64, ITA 2007 to set £2 of the loss against his other income for that year, allowing a claim to then be made to carry the loss back under Sch 2, FA 2021. Peter has no taxable income in 2020/21.

Rachel will be liable to HICBC in 2020/21 as her income exceeds £50,000. She lived with Peter throughout that tax year, and Peter was in receipt of child benefit. However, as Rachel is not within self assessment and as the couple have separated by the time the loss has been finalised, she is unlikely to be aware of this fact. The ruling of the Upper Tribunal in The Commissioners for HM Revenue and Customs v Jason Wilkes [2021] UKUT 0150 (TCC) means that although Rachel is chargeable to HICBC, HMRC would not be able to use a discovery assessment to collect the tax due. There is time for HMRC to issue a Notice to file a return in respect of 2020/21, but it is unlikely that HMRC will identify the case in time. 

2019/20

Carrying the loss back to 2019/20 will reduce Peter’s income for HICBC purposes to £44,000 plus any other sources. We can assume, therefore that no HICBC will now be due and the reduction in charge will form part of the tax credit calculated for Peter as a result of the loss carry-back claim.

However, as Rachel’s income is in excess of £50,000 and she lived with Peter throughout the tax year, Rachel is also liable to HICBC in 2019/20, albeit at a lower amount than Peter was.

Example

Tom is a single parent with two young children. He is a partner in a firm of architects and has been allocated a share of profit of around £65,000 for many years. As a result, Tom has elected not receive child benefit in respect of the two children. In 2020/21 the firm was hit with a substantial legal claim which exceeded the insurance cover carried by the firm. Tom’s share of the resulting loss was £110,000, which he was notified of in November 2021. Tom has no other income sources.

2020/21

Tom has zero taxable income for the year and should withdraw his election not to receive child benefit in respect of 2020/21.

2019/20

Assuming that Tom takes the benefit of the loss carry-back provisions, he will need to make a claim under s64 in 2019/20 as he has no other income in 2020/21. The effect of this will be to reduce his income in that year to zero, so he will also wish to reinstate his claim to child benefit for 2019/20.

2018/19

Carrying the loss back further under Sch 2, FA 2021 will reduce his income in 2018/19 to £20,000, so he would also be entitled to reinstate payment of child benefit for that year. However, the time limit for withdrawing an election not to receive child benefit is two years after the end of the relevant tax year, so Tom is too late to make a claim – he would have needed to make the claim by 5 April 2021, at which point the losses were not finalised.

2.7 Student loan repayments

For those taxpayers within self assessment who are also liable to repay a student loan, the repayments due are calculated as part of the self assessment liability and payable as if they were tax.

The definition of income for the purpose of the student loan calculation is unique. It is given by reg 29, The Education (Student Loans) (Repayment) Regulations 2009, SI 2009/470 which has subsequently been amended several times. The income taken into account is the total income from Step 1 of s23, ITA 2007, that is income before any deductions for losses etc. Regulation 29(4) then lists the various deductions to be made from the total income, and reg 29(4)(h)(i) provides for a deduction to be made for losses relieved under s64, ITA 2007.

By taking Step 1 income as the starting point and then allowing a deduction only for losses under s64, ITA 2007, any claim for loss relief under Sch 2, FA 2021 is excluded and therefore cannot reduce the income for student loan purposes.

For some taxpayers, this may well influence whether they decide to make a claim under s64 for both years for which it is available (the year of the loss and the preceding year), and in particular, the trade off between a claim under FA 2021 or s64 in the year preceding the loss will need to bear in mind this extra point when weighing up the reliefs. The threshold for repayment of student loans for 2019/20 and 2020/21 (the only years for which this is a relevant consideration) are as follows:

Setting losses off under s64, ITA 2007 in preference to Sch 2, FA 2021 will only be in issue where the losses reduce income which is above the relevant threshold. However in some cases the impact could be considerable if the taxpayer is liable to Plan 1 or 2 and Plan 3 (which can run concurrently with Plans 1 and 2) as the repayment rate would be a total of 15% (9% for Plan 1 and 2 loans and 6% for Plan 3 loans). Note that Plan 3 applies to postgraduate loans.

2.8 Rates of capital gains tax

The carry back of a loss to earlier years also has the potential to reduce the amount of capital gains tax (CGT) paid on disposals in the year. As the capital gains are treated as the top slice of income, reducing the income by setting off a loss against it may allow more of the capital gain to fall below the income tax higher rate threshold, thus reducing the CGT payable in addition to the tax relief given though income tax.