We’re pleased to republish this article from Mark McLaughlin: experienced tax author, editor and consultant. The article looks at a form of income tax loss relief potentially available when an unincorporated business is transferred to a company.
Many businesses start out being run by sole traders or partners, who later decide to incorporate the business and operate through a limited company instead.
Aside from the commercial considerations, the tax implications of incorporation are wide-ranging.
Losses carried forward
One such tax implication is that incorporating a business involves the cessation of the former sole trader or partnership business. An income tax relief is available in certain circumstances where a business is transferred to a company. This income tax relief (which is not well-known) allows unused losses of the unincorporated business owner to be carried forward and offset against income the individual receives from the company.
For example, a sole trader’s losses may have been carried forward from earlier years, which remain unutilised. Without this relief those losses may be ‘stranded’, resulting in the former business owner being unable to use them.
Business transferred to company
However, loss relief may be available in such circumstances if four conditions are met (ITA 2007, s 86):
- A trade is carried on by an individual (i.e., as a sole trader or in partnership).
- The trade is transferred to a company.
- The consideration for the transfer is wholly or mainly the allotment of shares to the individual(s). HMRC take the view that where the consideration is expressed in the transfer agreement to be cash, but the whole amount is subscribed for shares in the company, the shares may be regarded as the consideration for relief purposes; see HMRC’s Business Income manual at BIM85060).
- In the case of any individual to whom shares are allotted, that individual’s total income for the relevant tax year includes income derived from the company.
If these conditions are all satisfied, for the purposes of carry-forward trade loss relief, the individual’s income from the company is treated as trading profits of the relevant tax year carried on by the individual (or if the trade was carried on by the individual in partnership, their income from the company is broadly treated as the individual’s partnership profit share).
Loss relief is available for the tax year in which the trade is transferred if the individual is the beneficial owner of the allotted shares and the company carries on trading up to 5 April in that tax year. Loss relief is also available in subsequent tax years if the same conditions are satisfied throughout the tax year.
Flexible friend
The loss relief provisions state that the income derived from the company may be dividends on the shares or otherwise.
The statutory reference to ‘or otherwise’ in this context is taken to mean remuneration, interest, or rent, in addition to dividends.
Check the fine print
Helpfully, this income tax loss relief applies not only to trades but to businesses which are not trades, such as rental property businesses; so, the relief is more flexible than the normal carry-forward trade loss rules (in ITA 2007, s 83), which apply to the offset of trading losses against income from the same trade carried on by the same person.
However, the loss relief rules where a business is transferred to a company are specific and concise. In Davis v Revenue and Customs ([2022] UKFTT 274 (TC)), the relevant conditions for loss relief were found not to have been satisfied on the transfer of a trade to a company.
Practical point
Strictly speaking, for the loss relief to be available the allotted shares need to be retained. However, HMRC guidance (at BIM85060) states that in practice, relief should not be refused so long as the individual keeps shares representing more than 80% of the consideration received for the business.
The above article was first published by Business Tax Insider.