Trading Loss Relief Against Capital Gains

Malcolm Finney outlines the utilisation of a little-known relief.

Tax planning is as much about ensuring the efficient offsetting of trading losses as it is about maximising post-tax income.

Generally speaking, income and capital gains are distinct categories, with each having their own specific legislation, and rarely do their paths cross. However, it is possible for a trading loss for income tax purposes to be offset against capital gains for capital gain tax (CGT) purposes. The effect is that there is a reduction in any aggregate CGT charge.

Trading loss relief

Trading losses are in many cases simply carried forward and offset against future trading profits from the same business. Such losses can be carried forward indefinitely. However, under this option, relief is pushed into the future which is in principle less attractive than would be the case if immediate relief could be obtained.

One option under which immediate relief may be available is where a trading loss for a tax year is offset against the taxpayer’s total income of that tax year and/or the previous tax year. Where the loss is to be offset against total income of the current and previous tax year, offset against the current tax year takes precedence. However, since 2013 a cap has been placed on the amount of relief which can be offset in this manner; the cap is equal to the greater of 25% of income or £50,000.

Immediate offset is also available where a trading loss for a tax year is offset against capital gains of that tax year or the preceding tax year. For this purpose, the trading loss is effectively treated as a capital loss.

Not straightforward

However, the relief is not as straightforward as it might appear.

The taxpayer must first have offset the trading loss against other income of the same tax year. Only if there is insufficient other income to absorb the trading loss can the excess trading loss element be offset against capital gains of the tax year. This excess amount is referred to as the ‘relevant amount‘.

The capital gains available for offset are those of the current tax year but reduced by capital losses of the same tax year and any unused capital losses brought forward from previous tax years but not reduced by the relevant annual exemption for the tax year. This amount is referred to as the ‘maximum amount‘.

In the event that there are still unrelieved trading losses, these may be carried back to the previous tax year for offset in the same manner.

Example 1: Henry’s effective offset of trading losses against capital gains without restriction

Henry is a sole trader.

For the tax year 2017/18, he makes a trading loss of £50,000 and has taxable income of £40,000.

His capital gains for the tax year are £110,000 with capital losses of £50,000 and unutilised brought forward losses of £40,000.

The relevant amount = £50,000 – £40,000 = £10,000.

The maximum amount = £110,000 – [£50,000 + £40,000] = £20,000.

Note that as the relevant amount is less than the maximum amount there is no restriction of the offset of unused trading loss against capital gains.

Accordingly:

£ £

Capital gains 110,000

Less:

Capital losses (50,000)

Trading losses treated as capital losses (10,000)

Capital losses brought forward (38,700)

(98,700)

11,300

Less: annual exempt amount ( 11,300)

NET CHARGEABLE GAINS NIL

Note: the unused capital losses brought forward are limited to £38,700, so as to ensure sufficient chargeable gains remain in charge to allow full use of the annual exempt amount.

Example 2: Mary’s effective offset of trading losses against capital gains but restricted

Mary is a sole trader.

For the tax year 2017/18, she makes a trading loss of £50,000 and has taxable income of £15,000.

Her capital gains for the tax year are £110,000 with capital losses of £50,000 and unutilised brought forward losses of £40,000.

The relevant amount = £50,000 – £15,000 = £35,000.

The maximum amount = £110,000 – [£50,000 + £40,000] = £20,000.

Note that as the relevant amount is greater than the maximum amount, a restriction applies to limit the amount of unused trading loss available for offset against capital gains.

Accordingly:

£ £

Capital gains 110,000

Less:

Capital losses (50,000)

Trading losses treated as capital losses (20,000)

Capital losses brought forward (28,700)

(98,700)

11,300

Less: annual exempt amount ( 11,300)

NET CHARGEABLE GAINS NIL

Note: the unused capital losses brought forward are limited to £28,700, so as to ensure sufficient chargeable gains remain in charge to allow full use of the annual exempt amount.

Rates of tax

The rates applicable for income tax are currently 20%, 40%, and 45%. Those applicable for capital gains tax are 10% and/or 20% for non-residential capital gains, and 18% and/or 28% for residential capital gains.

Looking at these rates, logic dictates that trading losses should ideally be offset first against income not capital gains in view of the higher rates applicable to income. It may, therefore, be more tax-efficient to simply carry forward losses rather than offsetting against capital gains; however, this ignores the time value of money. As to the best option, this will depend upon the facts of the individual case.

Practical Tip:

Before deciding on the manner of any trading loss offset, examine the likely future trading position and the timing of any capital gains both realised and realisable.