As the tax return deadline approaches, businesses are faced with a major challenge: They not only need to communicate their tax returns to the HMRC, but also their previous year’s profits. Small businesses, self-employed individuals, and freelancers need to take the cash inflow and outflow principle into account when calculating their profit. But what exactly does this mean? This guide will help...
Not every year goes as expected and sometimes it could be the case that companies don’t make as much profit as they did in previous years. When expenditure starts to exceed revenue, you will find yourself in a loss position. It’s not all doom and gloom though, as you may be able to carry your losses forward to use in the next few years. How you can do this depends on whether you’re using the accruals basis or the cash basis. Using the accruals basis, there are four basic ways to obtain tax relief for a trading loss, but your business must be aiming to make a profit; losses for a hobby don’t count. With the cash basis, you can only use your trading losses by carrying them forward to use in future years.
In order to work out whether this is something that could help you and your business, you first need to know the difference between loss carryforward and loss carryback.
The difference between loss carryback and loss carryforward
The former is a provision that allows an individual or business to use a trading loss or net operating loss (NOL) in one year in order to offset a profit in previous years. The latter follows the same principle but the tax loss is carried over to an upcoming year, rather than being used in reference to a past one.
Losses used for these provisions must be trading losses - not losses on investments.
What is a trading loss?
A trading loss is a loss taken in a period where a company’s allowable tax deductions amount to being greater than its taxable income. The company’s trading loss can generally be used to recover past tax payments or be used to reduce future tax payments by making a company unprofitable for tax purposes. Here is an example to put things into perspective:
Company X has a taxable income of £1,000,000 and tax deductions of £1,300,000. This means its trading loss is £1,000,000 - £1,300,000 = - £300,000. Since there was no income to tax, Company X won’t pay any taxes that year.
But what happens if Company X makes a lot of money the next year? If £250,000 of taxable income is made and the company’s tax rate is 40%, then £100,000 would need to be paid in taxes (£250,000 x 40% = £100,000). The trading loss incurred last year can be applied to this year’s taxes, which will reduce it significantly, maybe even to zero.
It would also be possible for Company X to carry the trading loss back and use it for previous years, rather than future years.
The great thing about trading losses is that they provide relief to your company if needed. If your company isn’t doing well, the trading loss is there to indicate that your business is unprofitable for tax purposes. Some companies are actually bought only because of their trading losses.
Who can use loss carrybacks and loss carryforwards and how?
There are detailed rules regarding the possible offset of losses. Loss carrybacks are allowed within limits, and carryforward is generally allowed and doesn’t have a time limit.
Here are three important points when it comes to income losses:
- Trading losses may be set off against any other source of profit or gains in the same year. It’s also possible to carry them back one year or three years if the business is no more (terminal losses) against any other source of profit or gain, or can also be carried forward without a time limit against profits of the same type of business.
- Non-trading deficits can be offset against any other source of profit or gains in the same year, may be carried back one year against non-trading credits, or another option is to carry them forward without time limit against non-trading profits.
- It’s possible to offset any property losses against any other source of profit or gains in the same year, or they may also be carried forward without time limit against profits of any sort- They cannot be carried back, however.
Non-trading companies may deduct non-capital management expenses from the total profits they incurred when managing their investments. Income losses are usually offset against capital gains of the same accounting period, capital losses can’t be used to offset against any type of income.
Reform of the corporation tax loss rules
In April 2017, the plan was to make changes to UK corporate tax loss in order to increase flexibility for losses that have been carried forward. However, this hasn’t yet been implemented as it hasn’t been passed through a Finance Bill yet. The changes aimed to achieve:
- Increased flexibility in use of carried forward corporate tax losses and group relief
- Companies with profits over £5m can only offset 50% of their profits against losses carried forward in a single year
- Groups may have to adjust their tax predictions and estimated profit in case of delays in using losses
These changes can be beneficial to some companies, but may restrict others; namely those with profits in excess of £5 million since they will suffer loss restrictions and can only neutralise 50% of their profits against losses carried forward in a single year. The restriction would affect carried-forward losses that arose at any time, not just before these rules took effect. The reform means that the extent to which losses can eliminate profit is restricted so that large companies end up paying tax in the accounting period in which they make their profits.
How to work out profit or loss for Corporation Tax purposes
Limited companies must pay Corporation Tax on profits. The profit or loss is worked out by making the usual tax adjustments to the figure of profit or loss shown in your company or organisation’s financial accounts. Don’t forget to:
- Include any capital allowances since these increase the loss
- Include any balancing charges since these reduce the loss
- Omit any losses or gains that might be made from selling or disposing assets
- Include annuities and any donations made to charity
Information on how to correctly fill out the forms can be found on the GOV.UK website.
How to claim a loss carryforward or loss carryback
To carry a trading loss forward: If you haven’t used trading losses in any other way, they will be offset against profits in the same trade. When you fill in your Company Tax Return, it will happen automatically so you don’t have to do anything yourself.
To carry a trading loss back: If you decide not to carry a loss forward, you can claim for the loss to be offset against profits for the previous 12 month period. If you’re offsetting a loss against an accounting period where you’ve already paid the tax due, HMRC will send you a repayment. However, this can only be done if your company or organisation was carrying on the same trade sometime in the accounting period or the twelve months prior.
Here is an example of how it works:
Say that your company has a loss of £10,000 in the accounting period 1st January 2015 to 31st December 2015, and profits of £30,000 in the 12 months prior to that. It’s possible to carry back the £10,000 loss so that it can be offset against the profits for the previous accounting year, which would reduce them from £30,000 to £20,000 (£30,000 - £10,000).
If an accounting period falls on both sides of the 12 month period, the profit for that period will be apportioned and the loss can only be utilised against that portion of the profit falling within the 12 month period.
Using the same amounts as in the above example; if the business has recently changed its accounting date, so that the accounting periods and profits of the preceding periods were 1st July 2014 to 31st December 2014, £2,000 and 1st July 2013 to 31st July 2014 £10,000, you are able to carry back £2,000 of the loss so you can cover the whole of the profit in the period ending 31st December 2014. It’s not possible to carry back the entire balance of the £6,000 loss since only 6 months of the profits of £10,000 fall into the preceding 12 months of the loss making period. This means that only a £5,000 loss (6/12 x £10,000) can be used and the £1,000 balance left over can then be carried forward to the year ending 31st December 2016.
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