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Markel Tax

15 Sep 2020

Incorporation and property – possible pitfalls

The tax consequences of incorporation of a business or investment activity that includes a freehold or leasehold property among its assets has been a recurring question since long before the author started working in tax, but in recent years the number of requests to assist with transferring property to a company without any CGT or SDLT has snowballed.

In addition to the possible pitfalls that can arise on the transfer of the property from personal ownership to company ownership, which I will return to later in this first of a series of articles, the focus solely on the tax position of the transfer misses some of the other considerations that should be taken into account in making the decision.

Exit route and profit extraction

Corporate ownership of property currently results in rental profits being taxed at the flat rate of 19%. This is the current rate and both the headline rate and the effective rate of tax could go up in the future. While the intention is to reinvest the profits into expansion of the portfolio the corporate route is currently tax efficient.

When intentions change, what is the tax position? If building a portfolio to sell on retirement, what will the rate of capital gains tax be when the company is sold? If the properties are sold, or even if the rental profits need to be extracted for personal use, what will the rate of income tax be when the profits are extracted, and will the combined impact of the double tax charge be higher than if the properties had been owned personally?

If the exit route is to hand an investment portfolio over to the next generation, is the taxpayer aware that shares in an investment property company are subject to inheritance tax at the current full rate of 40%?

Capital Gains Tax

Turning to the tax liabilities that might arise on the transfer of property to a company, the first tax that we will consider is capital gains tax (‘CGT’). Unless any reliefs or other reductions to the tax liability apply then the transfer on incorporation will be subject to CGT based on the market value of the properties at the time of incorporation, as the company will be a connected party to the individuals’ transferring the property.

The rate of CGT on transfers of residential property is 28% for gains above the basic rate limit and 18%. For gains below that limit for non-residential property the rates are 20% and 10% respectively.

CGT incorporation relief

A relief is available on incorporation of a business under section 162 TCGA 1992 (‘incorporation relief’), and this can include the incorporation of a property rental business. There is unfortunately no statutory definition of business for incorporation relief, and references to a “UK property business” for income tax purposes should not be taken to confirm that a business is being undertaken for the purposes of claiming incorporation relief.

If it can be established that a property rental business is being undertaken then the operation of the relief still needs to be considered. Full relief is not a given, especially for a highly geared property business.

The relief requires the consideration for the transfer of the property rental business to be satisfied wholly or partly by the issue of shares, and operates by reducing the original tax base cost of the shares by an amount equal to the gain heldover. If any cash or consideration other than shares is received, then the gain heldover is proportionately reduced and part of the gain is immediately chargeable.

By concession, HMRC accept that the assumption of liabilities does not count as consideration, but it should be noted that this is only by concession and strictly the assumption of liabilities would form part of the consideration other than shares, and therefore result in a CGT liability. Should HMRC become aware that the concession is being abused, perhaps because the original debt remains in place with unchanged terms resulting in an advantage compared to a corporate purchase from the outset, then the concessionary treatment could be withdrawn or challenged retrospectively.

Even where HMRC accept that the concession applies, care needs to be taken that cash consideration is not unintentionally received, resulting in a CGT liability. For example, a new lender advances funds to a company which then uses those funds to pay off the individual’s liability to an old lender; this would be treated as cash consideration as the company has not assumed the liability for the old debt. Even when re-financing with the same lender the old debt should be assumed by the company before the new debt is advanced to repay the old debt.

Final thoughts

When considering the incorporation of a business or investment activity that includes property, have you made sure that you have considered exit routes and profit extraction?

On the assumption that you have, significant CGT liabilities can arise on the
transfer of property to a limited company, especially if a business does not actually exist. This is generally a matter of fact, and HMRC are no longer prepared to give non-statutory clearances on matters of fact, so ultimately it is a matter of judgement based on the facts. Even where a business does exist care will still need to be taken to ensure that, again as a matter of fact, the company assumes the liabilities that were previously personal responsibilities.

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Next article in series

15 Sep 2020

Business consolidation and VAT risk: buying a business