UK: Maximising the benefit of trading losses

Utilising those trading losses therefore becomes critical. Many businesses diversified in order to stay afloat during lockdown. The media was full of stories of the local pub which became a grocery delivery service, the brewery making hand sanitiser and the clothes manufacturer making PPE. In addition, there were tales of restaurants crowdfunding income to enable them to cook and donate meals to the NHS. 

In response to the new offerings by businesses across the UK as they adapt to COVID-19 restrictions, HMRC updated one of its manuals in June, focusing on the implications of changes to trading activities arising as a result of the current pandemic. Although HMRC has tried to take a business-friendly approach during the pandemic, there may be unintended tax consequences of the strategies that franchise businesses have adopted to survive. 

Trading losses

Ever since the financial crisis when a restriction was introduced to stop banks using all of their carried forward losses, there was an expectation that the restriction would be expanded into the rest of the market. There is a general belief that profitable businesses should pay corporation tax and not rely on previous years' losses to fully eliminate any taxable profits. Incrementally, more and more restrictions on the use of losses have been introduced, even before the current crisis which will clearly leave many businesses with a pot of taxable losses.

In any normal economic cycle, businesses may have trading losses which can be offset against certain profits to reduce their taxable profits. A company with a trading loss in any given period can always choose to:

• Set it off against accounting profits from the same period and carry back to set it against profits from the previous 12 months
• Do nothing in the current period and carry it forward to set off against future profits, and/or
• If it is a member of a group of companies, surrender the loss by way of group relief to another company to offset that company's total profits for the period.

This is subject to various restrictions and anti-avoidance rules. New rules have been in place since April 2017 which limit the amount of carried forward losses in excess of £5 million which can be used each year to 50% per year. Although this mainly affects larger companies and groups, there may be other businesses which are unexpectedly brought within the regime as a result of having 3-6 months of no to very low trading during 2020.  

In order to carry forward losses, a business must meet a number of conditions including that the trade did not become "small or negligible" in the loss-making period. HMRC's new guidance does not refer to the "small or negligible" condition in the context of businesses with furloughed staff and minimal turnover due to lockdown, but it is difficult to see that HMRC would seek to argue that a business could not carry forward its losses incurred during lockdown because that business was suffering the effects of lockdown.

Finance directors will also need to decide when the business will get the maximum value from its losses. If a business expects rates of corporation tax to increase, the future value of its trading losses will also increase. Should the franchise business, therefore, carry forward those losses to set against future profits where they might be worth more, or to carry back to last year's profits to provide a more short-term cash bonus?

What constitutes a "separate trade"?

When a business starts an entirely new trade, this is normally treated as a commencement of a separate trade. However, if the new trading activity is similar to its existing trade, for example a dress factory switching to make PPE, or a flour producer switching to make smaller bags of flour to sell direct to consumers, in both cases using the same staff and premises, then this should not be treated as a separate trade. As a result, profits and losses can be merged with those of the existing trade.

Temporary break in trade?

The guidance also confirms that a temporary break in trading, triggered by the lockdown, will not constitute a permanent cessation of trade for tax purposes. A cessation of trade would prevent losses being carried forward to be used in future periods, unlike a temporary break.  However, the manual states that this is conditional on activities being the same, or similar, once trading resumes, to those carried on prior to the break. 

Businesses raising cash from the public

Many franchise businesses have sought donations of money from the public (and/or occasionally employees), to enable them to supply products or services. For example, restaurants have crowdfunded money to enable them to cook meals for NHS workers. HMRC's guidance states that these "donations" should be treated as taxable income and taxed accordingly. 

Revenue expenditure

Businesses may also have assumed that all their expenditure during lockdown will continue to be deductible. Certainly, in the cases of businesses which have diversified, for example to produce hand sanitiser for sale to the public, it should be clear that the related expenditure is "wholly and exclusively for the purposes of a trade". But taking again the restaurant example above, where meals were cooked and prepared for NHS workers, questions may be asked as to whether the expenditure on stock and staff was for the purposes of a trade or was philanthropic. If it were philanthropic, then HMRC's view is that the expenditure is not allowable.

Businesses will need to document their decision-making process to support any arguments that expenditure was wholly and exclusively for the purposes of the trade, although the guidance is very unhelpful on this point. It would seem counter-intuitive if a business were in a worse position as a result of keeping its staff employed rather than relying on the government furlough scheme, or simply making its staff redundant.

Deemed income

If a business donates stock to a charity it is not required to record a receipt for the donation.  However, in the case of the same donation to a non-charitable body, for example meals given directly to homeless people, the amount which the stock would have realised if sold in the open market at the time of the donation should be brought into account, although HMRC concedes that the market value of that stock in the middle of lockdown is likely to be quite low. This is not a change in treatment for donations, but in light of the sheer volume of businesses doing their part for their local communities and key workers, it may come as a shock to some SMEs. 

HMRC may come under pressure to take a more generous approach in this area. Market value disposals combined with the lack of deductions for certain expenditure could have substantial implications for businesses. Struggling companies may have large accounting losses but taxable profits on which corporation tax will have to be paid. 

Businesses which have been making donations of goods to non-charitable bodies throughout the crisis should check those donations to see whether they will be required to recognise them as being sold for market value for tax purposes.