Tax Planning in an Economic Downturn

38 Moneen, Castlebar, Co. Mayo Tel: 094 9044786 Fax: 094 9044772 E-mail: info@donnellytax.com Website: www.donnellytax.com Tax Relief for Losses Tax Planning in an Economic Downturn In the current economic climate many business may be making losses. Claiming relief for these losses in the most tax efficient manner and on a timely basis could produce a welcome cash injection in many cases. Companies Current year trading losses can be carried back and set against the trading profits of the previous year. Rental losses can be set against the prior year s rental profit. Trading losses can also be used to shelter total profits (including for e.g. rental profits or chargeable gains) of the current or prior year on a value basis. Trading losses can also be set against the profits of a fellow group company. If companies are under common control but not in the required group relationship action to create a group structure should be considered as soon as possible. Consortium relief, involving the ownership of the loss making company by two or more profitable companies, could also be considered in appropriate cases. Change of year-end A change of year-end can be useful in maximising the amount of losses that can be claimed by the company or surrendered to another group company. For seasonal businesses, it can be beneficial to choose a year-end date just before a seasonal surge in income and profitability thus maximising losses for carry back and/or giving the maximum delay between earning the profits and paying the tax. Terminal loss relief Where a company ceases to carry on a trade and has incurred a loss in the final 12 months of trading, it can carry back that loss against the profits of that trade for the previous three years. The date on which the trade is ceased can have a significant impact on the amount of losses that can be carried back and should be considered carefully in each case. It may be worth considering a terminal loss relief claim and restarting the business in a new entity, but there are some anti-avoidance provisions in this area to be wary of. Individuals Losses in a trade or profession can be offset against an individual s other income e.g. director s salary, rental income etc (and that of their spouse) in the same year in which the loss arises. In a period of declining profits or losses changing the date to which accounts are prepared could reduce the taxable profits and/or help to maximise the losses that can be claimed against other income. An individual ceasing to carry on a trade can claim relief for a loss in the final year of trading against the profits of that trade for the previous three years under terminal loss relief provisions. Again, the date on which the trade is ceased can have a significant impact on the amount of losses that can be carried back and the selection of the cessation date, where possible, should be considered carefully. Depending on the circumstances, it may be possible to bring about a cessation so as to access a terminal loss relief claim. Partnerships In general, relief for a partner s share of the partnership losses will be available in a similar manner to that set out above for individuals i.e. set off against their total income and that of their spouse. However, in many partnership situations the tax relief on partner s losses may be restricted. The potential restriction applies to all types of partnerships but as a result of the downturn in the property market we have seen this issue come up more and more often recently in relation to property development/land dealing partnerships, including for e.g. where land was acquired jointly by a husband and wife. 1

A partner s ability to offset their share of the losses against their total incomes is restricted in the case of limited partners or partners who are not active partners (s1013 TCA). In such cases a partner s share of the loss can only be set off against income arising from that partnership. An active partner means a partner who works for the greater part of his or her time on the day to day management or conduct of the partnership trade. An individual with other business interests is likely to fall foul of these provisions and one or both spouses in husband and wife partnerships are also likely to be affected. The restricted losses can be carried forward for offset against profits arising from the partnership trade in the future, but if there are no profits made by the partnership in the future or if the future profits are less than the partner s losses to date then all, or a significant portion of the losses, will never be utilised. The inability to use the losses now against other income means that individuals are having to meet tax payments that might not otherwise arise in a time, when for many, funds are limited. In the case of land dealing partnerships where the restriction applies it should be possible to transfer parts of the property to each individual partner at no tax cost provided this is arranged carefully. The restrictions under s1013 only apply to losses etc where a partnership is involved. Losses (for e.g. arising from interest costs and site write downs see further below) in a trade carried on by one individual are not restricted and would be available for offset against their other income (and that of their spouse) under the normal provisions. Unlike many other tax reliefs, normal trading losses are not included in the specified reliefs for the purposes of the recently introduced restriction on the offset of tax reliefs by high earners. All Traders Where appropriate, provisions for bad debts and other items should be reflected in the accounts and tax relief obtained by way of a reduction in taxable profits or an increase in losses which can be tax relieved. Write Down of Trading Stock This is of particular relevance to the property development or construction sector in current market conditions and site and work in progress valuations should be reviewed. A write down from cost to net realisable value in the accounts will have the effect of either reducing current year profits or increasing losses which can be set against other income or profits. However, any banking covenants and related matters should be considered. As referred to above, in many partnership situations the offset of losses may be restricted. Any restructuring of the partnership e.g. into sole trades should be effected before any trading stock write downs take place. Early Tax Filings Where a tax refund is due the accounts preparation process should be speeded up and the relevant tax return filed as soon as possible so as to obtain an early repayment and avoid what is effectively an interest free loan to the Revenue Commissioners. VAT A VAT refund in respect of a bad debt can be claimed where it can be demonstrated that the debt is not recoverable. Improvements to Cash Flow Businesses should consider switching from accounting for VAT on an invoice basis to a cash receipts basis. The cash receipts basis is available where: Annual turnover does not exceed or is not likely to exceed 1M. Supplies of goods or services are at least 90% made to unregistered persons or to persons who are not entitled to claim a full deduction of the tax chargeable to them. Businesses which are not eligible for the cash receipts basis should consider the use of pro-forma invoices/requests for payment as an alternative means of delaying the payment of VAT until they have been paid by their customers. 2

Letting of residential property by property developers New VAT rules relating to property transactions were introduced with effect from 1/7/08. A letting of residential property is generally exempt from VAT and requires an adjustment of any VAT recovered on the property. The method of dealing with the VAT adjustment or claw back differs depending on whether the residential unit was completed before or after 1/7/08. While under the pre 1/7/08 rules the full VAT adjustment is payable for the period in which the exempt letting takes place a less harsh regime applies under the new rules. Lettings of units completed after 1/7/08 are not subject to a full VAT claw back, instead, the developer must make an annual payment to Revenue each year for the period that the property is let (up to a maximum of twenty years). For the purposes of these provisions, the Revenue are prepared to accept that a property is completed when it is first let by the developer. If units were first let prior to 1 July 2008 it may be possible to take some action now so as to trigger a recalculation of the VAT adjustment and bring the units in under the more favourable new rules. Capital Taxes Transfer of Assets and Other Planning Points Recent declines in asset values and possible future increases in tax rates means now is a good time to consider transferring assets. Passing Wealth to the Next Generation As all taxes on gifts, i.e. Capital Acquisitions Tax (CAT), Capital Gains Tax (CGT) and Stamp Duty are calculated by reference to the market value of the assets being transferred, it follows that while property and share values are low, it may be an opportune time to make a gift. The advantage of gifting property to children now is that any future increase in the value of the property will accrue to them directly and not form part of the parents estate on which CAT would arise in the future. Children can receive gifts from their parents up to the current maximum tax-free threshold of 414,799 without becoming liable to CAT and with the recent falls in values substantial assets could now be transferred free of CAT. The CGT position would also have to be considered. Despite the obvious tax advantages, many parents will have concerns about passing over assets with substantial value to children who are still relatively young. It is usually possible to deal with these concerns by arranging the transfer and subsequent ownership in a manner which does not give the children unfettered access to substantial assets or income. CGT Losses A further benefit can be gained as a result of falling asset values, through crystallising capital losses now that will be available for offset against gains on other assets in the current year with any excess carried forward indefinitely against future gains. If it is intended to retain the asset as a long term investment individually or within the family there are a couple of important points to note and plan to avoid where relevant. Firstly, under what is known as the four week rule, if shares of the same class are acquired within 4 weeks of the initial disposal the loss on that disposal will only be allowed against gains on a future sale of those shares. Secondly, losses on disposals to connected persons can only be set against gains on disposals to the same person. For example, if a parent intends to transfer shares to a child on which a CGT loss will arise they could consider selling the shares in the open market and gifting the proceeds to the child on the condition that they use the proceeds to purchase shares. By doing this, the parent will not be restricted in utilising the capital loss generated and the children still effectively receive a gift of the shares. There may also be potential to claim CGT losses in respect of assets which now have negligible value. 3

Taking Assets and Cash out of Companies The ownership of assets personally rather than through a company is often preferable for tax and other reasons. With current low values now may be an ideal time to take assets out into personal ownership, perhaps by liquidating the company. On a liquidation there will normally be two potential charges to CGT one on the disposal of the asset to the shareholders and the other on the deemed disposal of the shares. Depending on the circumstances it is sometimes possible to reduce or eliminate this second charge. If the company in question is carrying on a business which is to continue as before, it should be possible to separate the business and target asset into separate companies without any tax cost before a liquidation to extract the asset takes place. The extraction of cash from companies is also an area that people are focusing on at this time and this should be arranged in a tax efficient manner. Protecting Valuable Assets held in Trading Companies Trading companies often own valuable premises or items of machinery or may have used surplus funds to acquire property or other investments. Many business owners are concerned about the potential risk to these valuable assets arising from the trading activities carried on in the same company. In most cases it should be possible to separate the valuable assets from the trading activities without incurring any tax costs, provided this is done carefully, and achieve the desired protection. Recent tax changes and other matters Corporation Tax (CT) Exemption for Start-up Companies Newly incorporated companies which set up and commence a new trade can avail of an exemption from CT in respect of the profits for three years from the commencement of the trade, subject to meeting certain conditions. If the exemption is applicable, full relief is granted where the total corporation tax payable by the company for an accounting period does not exceed 40,000, which with a CT rate of 12.5% means profits of up to 320,000 can be earned each year free of tax. Marginal relief applies where profits are between 40,000 and 60,000. A qualifying trade for the purposes of the exemption does not include any trade or part of a trade previously carried on by another person in Ireland. If a new business is being commenced or an existing business is being expanded or changed in any way (e.g. new markets or outlets, new product lines etc) there is some scope for planning this in a manner which will make the maximum benefit from this new relief.. Incorporation of Existing Businesses Where a business carried on by an individual or partnership is generating profits in excess of the amounts required to fund the owner s cost of living it may be worthwhile transferring the business to a company. The excess profits not required personally at this time and which are liable to the higher income tax rate and PRSI/levies at up to 49.5% will instead be taxed at the CT rate of just 12.5%. The transfer of a business to a company can also often be organised in a manner which enables the owners to extract a sizeable sum at an effective tax rate of just 25%. Pension contributions by companies are not subject to restrictions that apply to individual contributors and this is a further reason to consider incorporating a business. 4

Tax Credit for Research and Development (R& D) Expenditure The tax credit available to companies for R & D expenditure was greatly enhanced in recent Finance Acts including an increase in the credit from 20% to 25%, the inclusion of expenditure on buildings partly used for R & D purposes and the refund of tax credits if the company is loss making. Many opportunities exist for organisations to optimise their R&D tax relief. If a business has overcome technological challenges to develop new products, processes, materials or services for their own use or for customers, then it may qualify for the generous R&D tax incentives. Many companies are not aware of the extent of their eligible activities, or that they are eligible at all. A company involved in any of the following activities may be entitled to an R & D tax credit: Setting up a new factory or production line where new technology is employed or new manufacturing techniques are used, Design and development of production processes for new products, Improvements in the efficiency of the manufacturing process of existing products to increase yield as well as reduce waste, by-products, or environmental impact, Manufacture of experimental qualification lots, Manufacturing process scale-up design and development work, Experimental production runs, including related labour and materials, Development of new products and processes, Development of sophisticated financial modelling and valuation techniques, Design and development of innovative integrated hardware and software systems, Mathematical modelling for the development of new financial products, financial engineering, spread betting or life industry products. Companies participating in these types of activities should consider the possibility of achieving substantial tax cash savings under the R&D regime. Tax Relief on Borrowings The interest paid on certain loans does not qualify for any tax deduction while other loans may only provide limited relief. A straight forward tax planning strategy is to ensure that the loans with limited or no relief are repaid first. In many cases (personal and corporate) a review of the overall borrowing position including possibly restructuring may lead to significant savings. Married Couples making best use of rate bands Many couples may have already arranged their incomes so as to maximise the additional 20% income tax band available for two income couples under individualization. If they have not done so this is an area that should receive immediate attention as regards transferring income between the spouses etc. Similar thought should be given to maximsing the use of the rate bands applicable under the new income levy. The above is only intended as an outline of the possibilities that are available across a number of areas. They are not exhaustive and we would recommend that you discuss your specific situation with us before taking any action. DONNELLY & CO April 2010 5