Tax relief for losses on incorporation

Transferring a loss-making business

HMRC has long had special rules to prevent businesses shifting losses for tax avoidance purposes. There has been some softening of the rules in recent years but there are still restrictions. Where the original and the acquiring businesses are both run by companies, special rules restrict the extent to which the latter is entitled to tax relief for losses made by the other company. A different set of rules apply if an unincorporated business, i.e. a partnership (or LLP) or owned by a sole trader, is transferred to a company.

Using losses to reduce tax

Usually, if a company’s trade makes a loss for a financial period it can use it to reduce its tax bill on income or profits it makes from other activities in the same or the previous financial year. Or it can carry the loss forward indefinitely to reduce tax on profits of a later year. Similar rules allow owners of unincorporated businesses to get tax relief for losses by reducing the tax payable on their other income or profits. However, losses of companies can’t be used to reduce the personal tax of its owners (shareholders) and neither can losses of an unincorporated businesses be used to reduce the tax on company profits.

Rules for previous business losses

It seems from the rules explained above that on two counts there’s no way of getting tax relief for losses made by an unincorporated business against profits from a company which acquires it. However, there’s an exception to these rules which is often overlooked.

Where tax relief for losses of an unincorporated business has not been used to reduce the tax bill on the business owner’s income, it can be used against the tax payable on the income (salary or dividends) they take from a company which acquires the loss-making businesses. There are two conditions for this:

• the company must carry on the same trade, alone or with other trades, as the unincorporated businesses
• the trade of the unincorporated business must be exchanged wholly or mainly for shares in the company which acquires it, i.e. the owner of the unincorporated business must be given shares by the company as compensation for transferring the trade.

Example. Acom Associates is a partnership equally owned by Andy and Winston. They transfer Acom’s business to Xcom Ltd. Acom’s final accounts show a loss of £60,000. Neither Andy nor Winston claim tax relief for their share of the losses. Xcom pays Andy and Winston only a small cash sum for Acom’s business; the main payment (at least 80%) is in the form of shares in Xcom. Andy and Winston can pay themselves salary, or if Xcom makes a profit, dividends, and use Acom’s tax losses to reduce or eliminate any tax they would otherwise have to pay on the income.

While dividends are usually the most tax-efficient method of taking income from a company, where tax relief for losses is available salary can be more tax efficient.

Claiming relief. To get tax relief for losses of an unincorporated business against later income from your company a claim must be made (in writing or on a self-assessment tax return) within four years following the tax year in which the individual wants to use the losses.