I’m a Sole Trader and I’ve made a loss in opening years; can I claim relief?
A sole trader or an individual in a partnership making a loss has zero taxable profit for the year. Keeping in mind that losses are calculated in the same way as profits, loss relief is an option for businesses that are run on a commercial basis and have the means of realising their profits. As a result, the relief claims available depend on the length of time the trade has been active; if it has started within the last four years, is a continuing trade or if the trade is no longer operational. This blog will focus on the opening years of the trade (ie. trading losses in the last four years).
Carrying back losses
Losses incurred within the opening four years of trade, in the interests of continuing trade or profession, can be relieved against other sources of income of the three tax years which precede the year of loss. For example, if trade starts 18 February 2021 (so in the 2020/21 tax year) the loss relief will be available off losses incurred in 2021/22, 2022/23, 2023/24, as well as the tax year trade commenced. Trading losses in each of these tax years can be carried back up to 3 years.
But keep in mind that the relief is not administered automatically, instead, a claim is required to be made on the first anniversary of 31 January succeeding the year in which the loss arose (ie. if a loss was incurred in the 2021/22 tax year the claim must be made by 31 January 2023).
What is HMRC’s view?
HMRC hold the stance that, when carrying back losses to earlier years the past tax returns are not amended. Rather relief is provided by calculating the tax adjustment and Class 4 NIC liability if relevant for the previous years. This figure is then included in the tax return for the year of loss.
To illustrate this case, consider a loss arising in the tax year 2020/21 which is then carried back to 2019/20 to produce a repayment of £1,500. This figure of £1,500 is entered into box 15; page TC2 of the tax return 2020/21.
A partial claim is not allowed. If a claim is desired then the carried bac loss is offset against earlier years first, which provides relief on all income for each year until the loss is exhausted. Take care as this could lead to waste of Personal Allowances or losses being offset at lower rates than usual.
Can I carry forward losses?
Absolutely. Trade losses incurred early on qualifies for a relief claim. Remaining losses after an opening year loss relief are permitted to be relieved in alternative methods, namely, losses carried forward.
For example, Serena began her trade in 2020/21 and realised a loss of £45,000. If her total income for each of the previous tax years was £10,000 Serena can make a loss relief claim. She also does not need to worry about the income tax relief cap as her total amount of tax reliefs does not exceed £50,000.
This also means that her net income for the previous three tax years is zero and her remaining loss is (£45,000 – (3 * £10,000)) = £15,000 which is permitted to be carried forward to offset future profits.
Suppose Serena then made a £50,000 profit in 2021/22 and other income of £5,000. Her net income would then be ((£50,000 – £15,000 = £35,000) + £5,000) = £40,000.
Are there any restrictions on claiming loss relief?
There are restrictions that may be applicable when claiming opening year loss relief, so it is imperative to be aware of such restrictions before beginning a new trade, more so if there are high upfront costs expected. The loss must arise from a trade, which is an important factor to consider as the business has only just started operation.
- Commerciality test: Loss relief is only available if the business is run on a commercial basis and profits can be reasonably expected in the period or appropriate time afterwards. Holding evidence of business plans that could support the claim of profit expectation is essential, even if losses are big and can be relieved at high tax rates. This also applies to instances where a partner leaves and then rejoins a partnership at a later time.
- Simplified cash basis: Not available for trades operating with the simplified cash basis. If losses can be utilised it is advised to not opt into this scheme.
- Cap on unlimited tax reliefs
- Non-active traders
- Tax-generated losses
- Farming or gardening businesses
How can I plan for the relief?
When planning for loss relief it is important to consider the following factors:
- Personal Allowances and Annual Exempt Amount: Aim to maintain these allowances
- Marginal tax rates: Prioritise offsetting losses against income taxed at higher rates for maximum savings
- Cash flow: Consider if it is worthwhile to claim relief for earlier tax years for cash repayment, or to claim relief at the highest marginal rate
- Income tax relief caps: Consider if reliefs will be lost if not claimed in the following year which they may arise
Class 4 NICs
HMRC consider losses as ‘negative earnings’ for Class 4 NIC purposes, so trading losses can only be set against trading profits. If otherwise (ie. set against non-trading income common in early trade loss relief), in the interests of Class 4 NIC this section of the loss is carried forward and will be set against future profits.
In the event the trader chooses to not end the year on the regular Financial or Tax year (31 March and 5 April respectively), trading profits could be taxed twice according to basis period rules. This amount is known as the ‘overlap profit’ and is only relieved if the accounting date changes or trade terminates. However, a loss is only identified on the earliest period so a double relief cannot be claimed.
For more information or if you’d like to discuss our Sole Trader services, feel free to contact us.