Not understanding the difference between business income and informal income can have serious consequences. This article explains how to adjust tax on informal income, i.e. hobbies.
Losses and Profits
You’re not alone if you think that the tax rules seem to be skewed in HMRC’s favour, but actually, they usually work both ways. For example, if you make a profit from trading, you’ll have to pay tax on it, but equally, a loss can be used to reduce the tax on your other income. However, this rule can be tricky, as Mr Patel (P) discovered when HMRC kicked out his claim for loss relief.
Trade or Personal Loss?
HMRC challenged P’s claim at a Tribunal because in its view it related to non-business transactions and so was a personal financial loss and not one arising from a trade. Non-trading losses can’t be set against taxable income, and it’s not just HMRC being awkward.
Trading Tests
HMRC and tax specialists refer to the so-called “badges of trade” to decide if a trade exists. These tests were set out in a court judgment decades ago but remain valid today. One of the tests to establish if a trade exists is that there must be an intention to make a profit from a business. In P’s case, the Tribunal extended this test a little further.
Incapable of Making a Profit
P started two “businesses”, neither of which made a profit because, in the Tribunal’s view, he was inexperienced and couldn’t devote enough time to them. Neither venture was capable of making a profit without P reducing the hours he spent in his main job. In essence, P didn’t have the business acumen or time to devote to making his business profitable.
Tip. If you start a business that’s risky, especially if it’s small and run from home, it might be difficult to prove your intent to make a profit. Producing a business plan at the outset to show HMRC in the event of a challenge would help your case for tax relief in the eventthat the business made a loss.
Putting the Boot on the Other Foot
The ruling in P’s case is useful, not just for guidance on when losses are deductible, but for countering HMRC if it claims money you make from a hobby is taxable. Its view has always been that if you advertise your hobby in a newspaper or online, you’re probably trading. But the Tribunal’s judgment, supported by HMRC, dispelled that idea. If you don’t have the time or intention to carry on a trade,the profit you make from isolated sales isn’t liable to income tax.
CGT or Not?
While you might be happy that you don’t need to declare profits from your hobby as income, you must also consider if you need to report them as a capital gain. The good news is that not only are the first £11,300 (for 2017/18) of gains exempt for a tax year, but there’s another less-known exemption, known as the “chattels exemption”. Broadly, it means that if you sell an item for less than £6,000, any gain you make is exempt from capital gains tax.
