restriction of relief: tax-generated losses
S74ZA Income Tax Act 2007 (ITA 2007)
S74ZA ITA 2007 is a targeted anti-avoidance measure which prevents sideways relief (relief against general income or early trade losses relief) or capital gains relief where the loss arises from relevant tax avoidance arrangements. ‘Trade’ includes professions and vocations.
The legislation is specifically targeted at persons who enter into tax avoidance arrangements with the purpose of obtaining a tax reduction by way of sideways loss relief. It will have no relevance for the vast majority of taxpayers who do not enter into such arrangements.
The restriction applies to losses which arise as a result of tax avoidance arrangements entered into on or after 21 October 2009. See Commencement rules below for details.
This restriction applies if:
- a person makes a loss for a tax year from carrying on a trade, profession or vocation and
- the loss arises directly or indirectly in consequence of, or otherwise in connection with, relevant tax avoidance arrangements.
Relevant tax avoidance arrangements
These are defined as arrangements to which the person is a party, and the main purpose, or one of the main purposes, of the arrangements is the obtaining of a reduction in tax liability by means of sideways loss relief.
The term ‘arrangements’ is widely drawn and includes any agreement, understanding, scheme, transaction or series of transactions, whether or not legally enforceable.
Whether a transaction forms part of a series of transactions, or a scheme, or an arrangement is in general a question of fact but this conclusion will follow in any case where one transaction would not have taken place without another transaction, or would have taken place on different terms without that other transaction. However, it is not necessary that transactions must depend on each other in this way in order that they form part of a scheme or arrangement.
Obtaining of a reduction in tax liability
For the legislation to apply it is a condition that the main purpose, or one of the main purposes, of a person being party to the arrangement(s) is the obtaining of a reduction in tax liability by means of sideways loss relief.
The fact that a reduction in tax liability is an inevitable outcome if sideways loss relief is allowed does not mean that a main purpose of the taxpayer must be to obtain a tax advantage. In the case of the vast majority of taxpayers, their purpose for entering into a transaction will be determined by commercial considerations and tax relief is an incidental consequence. However, in the case of an avoider the main purpose, or one of the main purposes, is always the securing of a tax advantage.
In applying this condition it is, therefore, necessary to consider the purpose of the person entering into the arrangements and the relevant circumstances. Factors to consider are:
- the overall economic objective: was the transaction inextricably linked to a core commercial activity and in a form not driven by considerations of tax advantage,
- if the objective is one which that parties involved might ordinarily be expected to have, and if the transaction giving rise to the reduction in tax liability would have otherwise taken place at all;
- if the objective of the arrangements is being fulfilled in a straightforward way or whether the introduction of any additional, complex or costly steps would have taken place were it not for the reduction in tax liability that could be obtained;
- if the reduction in tax liability would have been of the same amount without the arrangements and if the transaction would have been made under the same terms and conditions;
- if the loss has arisen in connection with a marketed tax avoidance scheme.
Restriction of losses
Where S74ZA ITA 2007 applies no sideways relief or capital gains relief may be given for the loss. It may, however, be carried forward against any profits of the same trade, profession or vocation.
Qualifying film expenditure
S74ZA ITA 2007 does not apply to qualifying film expenditure as defined in S74D ITA 2007.
S74ZA ITA 2007 applies in relation to a loss if it arises directly or indirectly in consequence of, or otherwise in connection with arrangements, or any transaction forming part of arrangements, which are entered into on or after the 21 October 2009 unless the arrangements were, or any such transaction was, entered into under an unconditional contract made before 21 October 2009.
Examples of how the legislation applies in particular circumstances are set out below.
Example 1 - loss from a marketed tax avoidance scheme
William is in employment and expects to receive a bonus of £250,000 that he wishes to shelter from tax. William enters into a scheme that is being marketed by a tax adviser, under which arrangements are put in place to generate a contrived partnership loss through a series of transactions involving non-resident parties and circular loan finance. William’s share of the contrived partnership losses is £250,000. He claims the loss for set-off against his employment and other income and seeks a repayment of tax.
The loss arises in consequence of relevant tax avoidance arrangements. To decide whether a main purpose of those arrangements is to obtain a reduction in tax liability by way of sideways loss relief, it is necessary to look at all the circumstances in which the arrangements were entered into, including the participant’s overall economic objective. In this case it is clear that the main purpose of William entering into the arrangements was to obtain a reduction in tax liability by means of sideways loss relief. S74ZA ITA 2007 therefore applies and no sideways loss relief is given for the loss.
Example 2 - loss arising to an individual from his trade
Raj carries on a manufacturing trade. He also has a large portfolio of property. This property business makes annual profits of £150,000. Raj incurs capital expenditure of £50,000 on new machinery for the manufacturing trade, funded by a bank loan on normal commercial terms. Raj anticipates that the expenditure will qualify for tax relief in the form of capital allowances.
Shortly after the machinery has been installed one of Raj’s main customer goes into liquidation and defaults on payment. At the end of the tax year Raj has a trading loss of £100,000 which he claims for off-set against the profits from his property business.
The transactions giving rise to Raj’s trading loss are ordinary trading transactions. Although he anticipated that the new machinery would qualify for Annual Investment Allowance this is incidental to his main purpose in acquiring the new machinery which is that it was needed for the operation of the business. Raj did not have a main purpose of accessing sideways loss relief and S74ZA ITA 2007 does not apply.
Example 3 - loss arising to an individual from a marketed tax avoidance scheme
Roopal carries on a building trade. She also has a large, mixed portfolio of investments which give rise to income of £150,000 per year. Roopal enters into a scheme that is being marketed by a tax adviser which is designed to generate losses through contributions to an employee benefit trust and which is said to circumvent the anti-avoidance legislation relating to employee benefit contributions. Roopal claims the loss, of £100,000, for set-off against her investment income and claims a repayment of £40,000.
The loss arises in consequence of relevant tax avoidance arrangements. To decide whether a main purpose of those arrangements is to obtain a reduction in tax liability by way of sideways loss relief it is necessary to look at all the circumstances in which the arrangements were entered into, including the participant’s overall economic objective. In this case it is clear that one of the main purposes of Roopal entering into the arrangements was to obtain a reduction in tax liability by means of sideways loss relief. S74ZA ITA 2007 therefore applies and no sideways loss relief is given for the loss.
Example 4 - loss arising to a partner from his profession
Sam carries on a profession in partnership. He also has significant income from investments. A client has filed a negligence claim against the partnership and is ultimately successful leading to the payment of significant compensation to the client which is not covered by the partnership’s professional indemnity insurance. As a result of the compensation payment, the partnership makes a loss of £1 million. Sam’s share of this loss is £100,000. He claims to set off the £100,000 against his investment income, leading to a reduction in his income tax liability of £40,000.
The transaction giving rise to the loss arose in the ordinary course of the profession. The loss does not arise in consequence of or in connection with relevant tax avoidance activities, as the main, or one of their main, purposes of the transaction was not the obtaining of a reduction in tax liability by means of sideways loss relief. S74ZA ITA 2007 does not therefore apply.