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Tony Wickenden: The limits to sideways loss relief

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Before I take a look at the proposed general anti-abuse rule (GAAR – the sound a tiger makes when asked to “open wide” by the feline dentist/vet) I thought I would have a quick look at the current provisions in relation to “sideways” loss relief – setting trading losses against other income. And then look at what is proposed to limit/prevent its use.

The recent publicity around tax avoidance spent some time focusing on loss relief schemes. Clearly, there is official discomfort with these sorts of scheme aimed at substantially reducing the income tax liability of the investor.

The proposed cap on amounts qualifying for income tax relief (the greater of £50,000 and 25 per cent of earnings) and the GAAR should combine to powerfully affect the use of sideways loss relief. But it is not that there have been no attempts to do so in the past.

The most recent attempt to limit sideways loss relief to genuine trading losses came in 2007 (for partners) and 2008 (for sole traders).

The limiting legislation provided that non-active partners and sole traders (see later) would have a limit placed on the total amount of relief that they could claim. BIM 72640 sums up the provisions for non-active partners as follows:

“A non-active partner for this purpose means a partner (including a limited liability partnership (LLP) member but excluding a limited partner) who does not spend, on average, at least 10 hours a week personally engaged in activities carried on for the purposes of the trade.

The restrictions only apply to losses made by non-active partners:

  • In early years of trading and

  • In respect of losses sustained on or after 10 February 2004.

Early years of trading for this purpose means the year in which the individual first started to carry on the trade and the next three years after that.

The total sideways loss relief that a non-active partner may be given in respect of their share of the partnership trading losses sustained for an early year of trading is restricted to:

  • The partner’s capital contribution to the partnership at the end of that tax year

less

  • The total of all relevant sideways loss reliefs previously given to the partner at any time in respect of losses from the same trade (reduced by any recovered relief).

For losses sustained by non-active partners on or after 2 March 2007 (whether in an early year of trading or in a later year) the £25,000 annual limit for sideways loss relief also applies.”

A big further step was taken in relation to tax-generated losses in 2010. A loss arising from relevant tax avoidance arrangements entered into on or after October 21, 2009 was made subject to the general restriction of relief for tax-generated losses introduced in FA 2010.

Under these 2010 provisions, contained in section 74ZA Income Tax Act 2007 (ITA) (a targeted anti-avoidance measure), sideways loss relief or capital gains relief, where the loss arises from relevant tax avoidance arrangements, is prevented.

The legislation is specifically targeted at persons (sole traders and partners) who enter into tax avoidance arrangements with the purpose of obtaining a tax reduction by way of sideways loss relief.

The restriction applies if:

  • A person makes a loss for a tax year from carrying on a trade, profession or vocation and

  • The loss arises directly or indirectly in consequence of, or otherwise in connection with, relevant tax avoidance arrangements.

Importantly, this “2010” purpose test does not apply to capital contributions made to a partnership carrying on a film-related trade where the trading loss, for which the partner is claiming sideways loss relief, is derived solely from relevant film-related expenditure. Guidance on what is relevant film-related expenditure is given in BIM 72614

The exclusion for film partnerships was clearly important as the recently publicised film schemes for generating sideways relief demonstrate.

Sole trader loss relief restrictions apply for losses made on or after 12 March 2008 in a trade carried on by an individual in a non-active capacity and section 74A ITA imposes an annual limit of £25,000 on the amount of losses for which sideways loss relief can be claimed.

So, in these limitations, we see the seed of the more recently proposed cap on income tax reliefs.

Tony Wickenden is joint managing director of Technical Connection

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