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Wednesday, 24th April 2024 |
| Tax loss optimisation in a bear market |
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| Mike Gaffney points out that attention to detail may be required to realise value for losses on investments where gains have hitherto automatically been taxed. |
The late James Gallagher, one of the pioneers of tax consultancy in Ireland, used to tell a nice story about tax losses.
There was a large meeting in the RDS when farmers were fully brought into the income tax net, for the first time, back in 1974. James had to give a talk to the farmers on how the tax rules worked, and they listened in silence.
Half way through, a man at the back put up his hand to ask a question, “So, if the taxman will take 65% of my profits, will he pay me 65% of my losses too?” James said, “Well… not exactly”. As he began to explain, about half of the farmers got up and left
the meeting!
Few investors can have escaped losses in recent volatile markets so it’s worth taking a look at how the farmer’s question would be answered in relation to relief for investment losses.
Capital Gains Tax (“CGT”) anti-avoidance
There are basic anti-avoidance measures which prevent taxpayers from taking advantage of losses where investments are not truly closed out.
Four week rule
It may be tempting to sell shares to crystallise tax losses and then buy back equivalent shares to maintain exposure. However where you buy and sell shares/securities of the same class within 4 weeks, any losses arising on the sale are restricted for offset only against future gains on disposal of securities of the same class as those purchased.
This means you must be prepared to ride the markets rollercoaster for at least 4 weeks to realise losses for tax purposes.
FIFO rule
You may have built up certain shareholdings over the long term, watching a gradual increase in the value of earlier acquisitions, followed by a sharp decline, with more recent purchases suffering the biggest losses. You would like to choose to sell the most recently acquired shares to maximise losses. There are FIFO (First in First out) tax rules to prevent this by deeming earlier acquisitions to be disposed of first.
Connected Party Rule
The possibility of selling to a family member (or other connected party such as a controlled company etc) to crystallise losses has also been covered off. Such losses can only be set off against gains realised on disposals to the same person. There are also rules to impose market value consideration on transactions between connected parties.
CFDs
Contracts for differences (“CFDs”) have seen a dramatic increase in popularity amongst private investors in recent years. They offer lower transaction costs (e.g. no stamp duty) compared with direct share investment, low upfront cash outlay and facilitate shorting where investors’ outlook is negative.
Assuming a private investor is not trading in CFDs, closing a CFD position gives rise to a capital gain or loss for tax purposes, taking into account notional interest and dividend flows.
Take Jack, who invested in a long 50,000 Irish plc share position at €2 per share. He placed a 20% margin with his broker and he paid a financing cost of 10%. A notional dividend flow of €5,000 arose before he closed out his position after 1 year when the shares were valued at €1.
Jack realises a CGT loss of €55,000 (€50,000 decrease in share value plus €10,000 interest less €5,000 notional dividend).
It will be available for offset or carry forward against other capital gains.
It is interesting that if, for instance, an investor closes out a CFD and buys back the same underlying share (without a CFD) in order to put the holding on a more stable footing for the future, then the restrictions under the 4 week rule above should not apply.
Are you trading?
Where losses are generated, it may be more beneficial to be classified as a trader rather than an investor, as loss relief would be available against other current year income taxable at marginal income tax rates.
Revenue review this area closely and resist such claims by individuals. They have not always been successful however and if a sufficiently sophisticated activity is carried on, it may be worth considering whether certain indicative features of “trading”, established over years of case law, can be argued to be present.
Spreadbetting
The absence of a tax liability on gains from spreadbetting has undoubtedly contributed to its growth. However, frequent betters may rue the fact that no relief is available for losses, except in the unlikely event that the circumstances support a trading analysis.
Offshore Funds
The idea behind the “offshore funds” legislation was to prevent taxpayers from “rolling up” income in a wide range of offshore entities in order to realise capital gains, instead of income which would be subject to high marginal tax rates.
The regime potentially applies to a range of situations where investors invest collectively overseas, for example, foreign institutional funds, property syndicates etc. Broadly it subjects most offshore funds to a special income tax regime and the rates applicable depend on whether the location of the fund is classified as “good” (EU/EEA or OECD countries with which Ireland has a double tax treaty) or “bad” (other locations).
The 2007 Finance Act made significant changes to what now falls within the regime and included measures grandfathering certain arrangements and not others.
This is a very complex area and the detailed treatment is beyond the scope of this article. However, the regime is an inequitable one in that, unfortunately, no tax relief is available in respect of losses incurred on the majority of offshore fund structures.
Irish “roll up funds”
Most regulated Irish savings products (e.g.institutional products and private qualifying investment funds (“QIFs”)) are taxable under a specific non-CGT regime which imposes a 20%/23% tax on certain events or deemed events. This special regime does not provide for loss relief, though, in certain cases, consideration might be given as to whether there is any scope for a claim, based on a detailed reading of the provisions.
“You should not be starting from here”
With banks reducing credit facilities and customers under pressure, many businesses are finding maintaining cashflow more difficult, while more critical than ever.
The owner of a private company may have cash available but how can it be injected tax-efficiently? Interest free loans are often seen as the solution. If profitability is not achieved however, a tax deduction is not normally available for losses incurred. This point is often discovered too late when the loss has already been made. There is anti-avoidance legislation to stop this loss being made allowable by methods such as converting the loan into shares.
If this had been planned carefully upfront, solutions may have been injection of redeemable preference share capital or provision of a formal loan, classified as a “debt on a security”. These would lead to recognition of a chargeable asset for CGT purposes, resulting in any losses being allowable.
Overseas property - FX issues
A common tax pitfall with overseas property investment may prove beneficial in the current market.
Non euro-zone capital investments are usually financed by local currency borrowings to provide an effective economic hedge. Where the investment does well and the local currency strengthens, investors are sometimes shocked to discover that their taxable gain is increased by fx gains which are not matched for tax purposes with allowable fx losses on the borrowing.
The flip-side is that this may yield more losses than expected in current markets, which is good news if they can be used to shelter some gains.
Take Tom who invested $100k in a US property and is selling for $80k. The Euro has strengthened from $1.38 to $1.58 since he invested. His loss of c€13k ($20k converted@1.58) is increased to €22k due to a loss of c€9k by virtue of Euro appreciation. However no CGT applies to the corresponding c€9k fx gain on the borrowing.
Transactions in land and buildings
There are specific CGT rules which apply to disposals of “development land”. It is worth noting that while you cannot shelter development land gains with non development land losses, there are no restrictions on the use of development land losses against other gains.
Special income tax rules also apply to developers trading in land and buildings. If you are trading in partnership with others,
you need to watch out for stringent restrictions on partnership losses which can catch normal commercial losses on common ventures.
There are distinctions in treatment between residential and non residential property trading. Residential is broadly defined by reference to whether land is zoned residential, has planning permission for residential development or is sold to certain approved bodies and is required for the purposes of the Housing Acts.
Trading and developing residential property is subject to a low 20% tax regime. However, you can opt out of this regime. This may be useful if there are losses and you have other income against which to set them.
If you are trading non residential property you have to value your property stock at lower of cost and net realisable value (“NRV”). As the definition of NRV is not the same as market value but takes into account future plans, current market conditions may not generate as many losses as might be assumed. Furthermore, future increases in NRV will be taxed.
Beware - October CGT
If you are realising gains and losses on sales of different assets this year and are budgeting for automatic offset, beware.
CGT must be paid in 2 instalments - by 31 October 2008 in respect of gains realised between 1 January and 30 September 2008 and by 31 January 2009 in respect of gains arising for the remainder of 2008. If, for instance, you have realised large gains in March and an even larger loss is expected in October, the strict position is that you must finance the CGT payment on the gain until your refund is claimed in order to avoid interest and penalties.
“Negligible Value”
In a situation where the value of your asset has plummeted and you need to utilise the losses but cannot dispose of the asset for whatever reason, the possibility of making a “negligible value claim” at least merits consideration.
This involves claiming access to the loss as if it had been crystallised on the basis that the asset is of negligible value. Although the law strictly requires the claim to be made in the same tax year, by concession the Revenue will allow a claim to be made within 12 months of the end of the year of assessment in which the asset becomes of negligible value.
In conclusion, the farmers in the RDS in 1974 were right. Profits are taxed but in bad times you may have to work hard to get relief for the losses. |
Mike Gaffney is a tax partner at KPMG.
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| Article appeared in the August 2008 issue.
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