Reform of corporation tax loss relief

The Government has released a consultation response document alongside draft legislation for implementing reforms to the tax treatment of carried forward loss relief. The Government has confirmed that it will take forward the proposed changes, though, following feedback, it will introduce some measures to reduce their complexity. In particular, as with the introduction of restrictions on corporate interest expense, the Government has rejected calls to delay the implementation of the changes or make any fundamental changes to their core features.

Background

At Budget 2016 the Government announced that it would introduce reforms to the UK loss relief regime to make the system more flexible for businesses, whilst ensuring businesses making substantial profits pay tax. In May 2016, a consultation document setting out details of the proposals was released. The consultation document, “Reform to corporation tax loss relief: consultation on delivery”, proposed that losses carried forward which arise from 01 April 2017 should be available to be set against any profits of the company carrying forward those losses and also within that company’s group. However, the Government also proposed that there should be a restriction on the use of such losses, such that only 50% of profits can be relieved through the use of such losses (subject to a £5m group allowance).

Increased flexibility

Under current rules, where a company incurs a loss as a result of its trading activities it is able to:

• relieve that loss against total taxable profits generated in the corresponding accounting period, including profits from other activities
• relieve that loss against total profits generated in the previous accounting period, and
• surrender that loss to another company in the group where it can be relieved against taxable profits generated in the corresponding accounting period.

Losses that have not been relieved against current or prior year profits to be carried forward and set off against taxable profits arising in future periods. There is no restriction on the amount of profit that can be relieved by carried forward losses, but there are restrictions on the type of profit that carried forward losses can be relieved against. In general, carried forward losses can only be set against profits from the activities to which they relate, rather than the profits of other activities in a company or the profits of other companies within its group.

It is the Government’s view that companies should have the ability to carry forward losses and set those losses against the taxable profits of different activities and the taxable profits of other group members. This will help to avoid relief for losses incurred from a particular source of income being stranded such that relief may be delayed or denied altogether due to a lack of profitability in that source of income. The losses included in the reform are trading losses (including a company’s share of a partnership trade loss), non-trading loan relationship deficits, management expenses, UK property losses and non-trading losses on intangible fixed assets.

However, since this increased flexibility will have a significant impact on the Exchequer, the increased flexibility will only be available for losses incurred from 01 April 2017. Losses that arise prior to this date will remain subject to the existing streaming restrictions in relation to the profit that they can be set against.

No changes are intended to be made to the treatment of capital losses. They will continue to be relieved only against chargeable gains, even where a company has taxable profits from other income sources in the year that a capital loss arises. This reflects the fact that companies have greater discretion over the point at which capital losses are recognised for tax purposes and also other major differences between the capital gains regime (such as the existence of roll-over relief and the substantial shareholdings exemption).

These changes will reduce the importance of the schedular system and, as a result, the Government has announced that it intends to ask the Office of Tax Simplification (OTS) to “explore the merits and practicality of reforms in this area”.

Carry-forward restriction

Under current rules, companies making substantial UK profits can end up not paying corporation tax for many years due to losses incurred from historic events. The Government takes the view that companies making substantial profits should pay tax and limiting the amount of profit that can be relieved with carried forward losses will address this situation as well as being consistent with the approaches taken in a number of other G7 countries. As such, the changes to be introduced will mean that, from 01 April 2017, the amount of profit that can be relieved by carried forward losses will be restricted to 50%.

It should be noted that the restriction will essentially affect the timing of relief for carried forward losses (rather than preventing their use entirely). Where a company’s carried forward losses are restricted, it will be able to carry forward any unused losses and set these against profit arising in future periods.

The consultation document proposes that the restriction should continue to apply by reference to the profit against which carried forward losses are eligible to be set. This means that relief for carried-forward trading losses arising before 01 April 2017 will be restricted to 50% of trading profit, whereas relief for carried forward trading losses arising after 01 April 2017 will effectively be restricted to 50% of profit across the group.

However, in response to adverse feedback on the calculation aspects of the rules, the Government will introduce a number of simplification measures, including giving companies total flexibility in how in-year reliefs are set against trading and non-trading profits for the purpose of computing the loss restriction and removing the requirement to use pre-April 2017 losses before post-April 2017 losses.

It is not suggested that any further restriction be introduced on the carryback of losses, however.

Importantly, the 50% restriction will only apply where more than £5m of carried-forward losses are being used across a group of companies in a year. In essence, each group will be given an annual allowance enabling up to £5m of taxable profits to be relieved in full by carried forward losses. It is proposed that groups have full discretion over where the allowance is used within the group. The Government expects that this measure will ensure that over 99% of companies will be unaffected by the restriction. However, the response document rejects calls to allow a simplified calculation in such cases. This is because companies will not be able to assess whether their relevant profits fall below the £5m threshold without preparing the calculation, and where the company is a member of a group, the test would need to be applied across all group members to determine whether the £5m threshold has been exceeded at group level.

For these purposes, the Government has decided to follow the definition of group used for group relief purposes. However, the Government is concerned that this definition is easy to break, by design, and would present a risk of abuse that groups could fragment in order to increase the number of allowances for which its group members would be eligible. The Government will therefore use the group relief definition as a basis for the new definition, but include additional criteria to ensure companies cannot easily break the group relationship for the purposes of gaining their own £5m allowance.

In response to concerns that the restriction would have a particularly adverse effect on fixed-term projects with high upfront costs, the new rules will allow a company that ceases trading to use any remaining carried-forward trade losses against profits arising in the final 36 months of the trade without restriction.

REITs

The Real Estate Investment Trust (REIT) regime grants an exemption from corporation tax to companies for the profits of their property rental business, conditional on 90% of the UK property rental profits being distributed to the REIT shareholder every year. Respondents to the consultation proposed that REITs should be exempt from these reforms on the basis that the restriction on the use of losses could artificially inflate the profit distribution requirement and that the purpose of a REIT is to tax the shareholders more directly. The consultation response notes this is an unintended consequence of the changes and will legislate to exclude REITs from the loss relief reforms.

Consortia

The new rules will allow consortium companies to surrender or claim post-April 2017 carried forward losses from members of the consortium according to the member’s interest in the consortium company in the accounting period in which the loss arose. Accordingly, the maximum losses a member of a consortium can claim will be capped at the entitlement it had in the period the loss arose.

Anti-avoidance

The Government is concerned that the greater flexibility in use of carried forward losses should not prove an incentive to new opportunities for avoidance behaviour, such as “loss-buying”. Therefore, the rules will include significant anti-avoidance provisions, including provisions to protect against:

• groups acquiring companies to use their carried forward losses (loss buying)
• losses being set against total profits or surrendered to group companies where the trade or activity that generated them has ceased or become small or negligible
• carried-forward losses being refreshed, so they can be used more flexibly (by extending the existing anti-loss refresh rules to include property losses and non-trading losses on intangible fixed assets), and
• arrangements with the main purpose of obtaining a benefit under the loss relief reform rules, for instance manipulation of the group structure to maximise the amount of annual allowance due or artificial inflation of profits to increase the losses that can be used under the loss restriction rules.

As regards loss buying, the response notes that risks are currently limited, because some pre-2017 carried-forward losses cannot be set against total profits and none of them can be surrendered to group members. However, the reforms will allow greater flexibility, and therefore the risks of abuse will increase as post-April 2017 losses are accrued. The Government will therefore introduce rules that specify that where a loss-making company is acquired:

• pre-acquisition carried forward losses cannot be surrendered into the new group for a period of five years
• the existing loss buying rules will continue to apply so if there is a change of ownership and one of the loss buying conditions are met (eg a major change in the conduct or nature of a trade or investment business), any pre-acquisition losses of the relevant trade or investment business will be forfeit (extending the time limit for considering whether the loss buying conditions have been met to five years after the change of ownership), and
• if in the subsequent five years there is a change in the nature or conduct of any trade or business against which post-April 2017 carried forward losses could otherwise be set, pre-acquisition carried-forward losses will not be allowed against profits of the trade or business the nature of which has changed.

In addition, the Government has previously indicated that targeted anti-forestalling provisions will be included in the final design of the legislation, potentially including a targeted anti-avoidance rule to protect against profit-shifting designed to accelerate carried forward loss use eg a group artificially shifting profits from a company that has no carried forward losses to a company that has pre-2017 carried forward losses.

Comments

Draft legislation has been released as part of the draft Finance Bill covering the core aspects of the rules. Further draft legislation is promised for January 2017 covering the remainder, including the anti-avoidance rules and the consortium relief rules.

Update

For detail of the further legislation released in January 2017, see "Reform of corporation tax loss relief: further draft legislation".