The proposals for reform were first announced at Budget 2016 and cover two aspects. On the one hand, the rules will be more generous, with increased flexibility over which profits can be relieved by losses, but on the other hand, less generous as the amount of losses which can be offset will be restricted to 50% of profits above an annual allowance of £5 million (on a group basis). Companies and groups which have substantial losses brought forward will therefore have to pay tax, despite those losses, where their profits exceed £5 million. This is a concept brought across from similar restriction for banks, which had accumulated substantial losses in the financial crisis, and is clearly a revenue raising exercise. Both changes will apply from 1 April 2017. The reforms only extend to revenue losses, so the treatment of capital losses will remain unchanged, so these can only be relieved against chargeable gains (and note the proposed reform to Substantial Shareholding Exemption). Revenue losses are trading losses, non-trading loan relationships deficits, UK property losses, management expenses and non-trading losses on intangible fixed assets. Also unchanged is the relief for carried back losses, so there will be no restriction on the amount of losses that can be relieved by carry back.
Currently, there are restrictions on the types of profits which can be relieved by brought forward losses, and relief (generally) can only be given for brought forward losses in the same company that incurred the loss. For example, a trading loss brought forward may currently only be relieved against trading profits arising from the same trade in the same company. The Government believes that this system is no longer consistent with international best practice and is overly restrictive. The proposal is that losses arising from 1 April 2017 which are carried forward will be able to be set against different profits in the company, and, against taxable profits of the group. This is helpful as it reduces the chance of losses becoming ‘stranded’, so they remain unrelieved. The new flexibility will not apply to losses arising prior to 1 April 2017, so it will be necessary to identify which losses arose pre and post that date.
This might have presented an opportunity to abolish the “schedular” system of computing taxable profits, but the Government has decided instead to ask the Office of Tax Simplification to consider the reforms as part its work on corporation tax computations. Furthermore, the current intention to restrict which profits pre 1 April 2017 losses can be offset precludes such an overhaul, and it is clear this is intentional: to limit the cost of these reforms.
Restriction on losses relieved to 50% of profits
The new restriction will not change the availability of loss relief, but it will change the timing of it where company/ group profits exceed £5 million per annum. The proposal is that the restriction will apply by reference to the type of profit against which losses are eligible to be offset. Thus for pre 1 April 2017 losses, the 50% restriction will apply to each separate type of income e.g. trading profits, loan relationships deficits, whereas for losses arising from 1 April 2017, the restriction will be 50% of total group profits in excess of the £5 million allowance. It will be for the group to decide how to allocate the allowance between different group members. Pre 1 April 2017 losses will be used in priority to post 1 April 2017 losses. Notably, start-ups will not be subject to any relaxations on the basis that the £5 million allowance is sufficiently generous.
For banks, the existing restriction on the use of losses will become more severe at a mere 25% of profits. There may be specific issues for other sectors, such as insurance (given the Solvency 2 requirements) and public-private partnership or private finance initiatives, and affected groups will need to make sure any concerns they have are raised.
The consultation document sets out proposals for the detailed approach for calculating the amount of losses that can be relieved in a given accounting period, by setting out the ordering of reliefs, and there is a series of worked examples to illustrate this. Whilst there is increased flexibility in how losses will be able to be used, it is still proposed that trading losses should first be relieved against trading profits first, and a similar approach may be taken with property losses. The result is that:
- carried-forward trading losses should be used against trading profits, with priority given to pre-1 April 2017 trading losses.
- carried-forward non-trading loan relationship deficits should be used against non-trading profits, with priority given to pre-1 April 2017 non-trading loan relationship deficits.
- any remaining allowance can then be allocated to total profits, allowing management expenses, UK property losses and non-trading losses on intangible fixed assets to be relieved; it will also allow post-April 2017 trading losses and non-trading loan relationship deficits to be relieved against total profits e.g. where a company has post 1 April 2017 trading losses but only non-trading profits.
The government is considering how the proposals will interact with other areas of tax legislation, such as proposed interest restriction rules which will apply from 1 April 2017, and the patent box.
Currently, group relief only permits the surrender of current year losses between group members. Under the proposals, carried forward losses in one group company will be able to be set off against the profits of another group member. Although the reforms might have presented an opportunity for significant simplification, a system similar to group relief is proposed involving surrenders and claims for the relief. This is disappointing as a number of other countries have tax consolidations which avoid this level of complexity. Whilst the current definition of ‘group’ will be carried over from the group relief rules for the surrender and claiming of losses, this will not extend to the annual allowance of £5 million. The rationale for this is that companies under the same economic ownership, but not grouped, would otherwise not be caught by the restriction. Instead, an alternative definition based on control is likely, for example either based on the accounting definition of control under IFRS 10, or on ‘association’ which covers companies under common control, or where one has a ‘major’ interest in the other (as with other tax legislation such as transfer pricing and controlled foreign companies rules).
Consortia will also be able to surrender or claim post 1 April 2017 carried forward losses.
Anti-avoidance measures and proposed expiry of losses
Anti-avoidance measures already exist to prevent the ‘refreshing’ of carried forward losses where this is tax motivated, and this will be extended to ensure that UK property losses and non-trading losses on intangible fixed assets are also caught. Measures are also expected to prevent the shifting of profits between group companies or other contrived arrangements to use up brought forward losses by, for example accelerating the recognition of profits.
Restrictions on the use of carried forward losses on a change in ownership are also expected to remain, to counter loss-buying. This will mean that when a company is acquired, its carried forward losses will only be able to be used against profits of the same trade or business. Similarly, the current rule that losses die when a trade ceases look set to remain. However, additionally, the government is looking to make losses expire once there is no possibility of them being used going forwards – this is more worrying, as whilst it cites this applying to companies in liquidation, it is not unknown for companies to emerge from liquidation. It would certainly not be appropriate for losses to expire on entering administration, as the point of administrations under the Enterprise Act is to help secure more corporate rescues.
The consultation period runs until 18 August 2016 and draft legislation will be published at the Autumn Statement to allow a period of consultation before its inclusion within Finance Bill 2017.