Avoid losing the right to sole-trader losses when incorporating your business

Facts of the case

Mr Davis (D) operated as a sole trader providing finance to a single used-car dealership to facilitate the sale of its vehicles. The dealer often defaulted on repayments and after several years of this D formed a company in 2005 (USL Securities Ltd) which carried on a similar business. D terminated his sole-trader business in December 2007. He sued the car dealership for unpaid debts. Despite judgment in his favour, D never received the money he was owed. This resulted in losses for which D claimed tax relief against income he received from USL.

Case for the taxpayer

Where a sole trader or partner transfers their business to a company, the rules allow losses from the unincorporated business to be set against income the sole trader/partner derives from the company, e.g. salary, dividends etc. Relief is allowed only if the loss-making business was transferred to the company which pays for the trade “wholly or mainly” by issuing shares in itself to the transferor.

Case for HMRC

HMRC threw a slew of counter arguments any one of which it said meant D was not entitled to the loss relief. Some arguments seem to us clearly wide of the mark, but HMRC often uses this scattergun approach in the hope that something will hit the target. However, the First-tier Tribunal (FTT), chose not to look at HMRC’s more tenuous arguments and restricted its consideration to the following:

• D had not transferred his trade but started a similar one through his company (USL)
• even if D had transferred his trade to the company, payment for it wasn’t “wholly or mainly” in the form of shares
• the company’s trade, while similar to that of D’s (car financing), was sufficiently different that it was not the same as that of the sole trader.

On the first point, the FTT’s view was that D’s sole-trader business continued after the company started trading. This indicated that the trade was not transferred. USL paid nothing to D to indicate payment for the transfer. On the second point, D paid cash for his shares in USL; they were not given to him as payment for his trade. One of the conditions for the relief was therefore not met. On the third point, the FTT sided with D; the trade of USL was the same type of trade as that run by D alone. This was a pyrrhic victory for D as the damage was already done by HMRC’s other arguments.

Last ditch argument

D made a last attempt to sway the FTT. He explained the commercial reason for forming USL was to take over the trade but with the protection of limited liability. His sole-trade business continued only for the purpose of ring-fencing the unreliable customer’s debts. D said that his claim only failed because of technicalities which the FTT had the power to overlook in accordance with the “Ramsay doctrine” (this says the purpose of the law can be applied rather than the strict wording if it’s ambiguous). The FTT found there was no ambiguity in the legislation and therefore the Ramsay doctrine wasn’t relevant. It would have taken little effort for D to meet the conditions of the relief, e.g. accepting shares as payment. The lesson is not to stint on formalities when it comes to tax.