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Markel Tax

11 May 2020

Residential property business incorporation

Landlords of personally-owned residential property were already expecting that the 2020/21 tax year would be challenging, even before the COVID-19 outbreak put pressure on receipts from rental income. This is the first tax year that the full impact of the change to restrict the tax deduction for residential property finance costs to the basic rate of tax will be felt, the change having been progressively introduced over the previous three tax years.

Example

Taxpayer owning residential properties with £180,000 of net rental income pre finance costs and £90,000 of finance costs. Taxpayer has £55,000 of employment income.

The 2020/21 tax liabilities on the rental income are shown for the following three scenarios, assuming that:

  1. the restriction had not been introduced,

  2. that the restriction applies in full, and

  3. that the properties had been transferred to a limited company and the taxpayer receives a dividend equal to the net rental income of the company.

Scenario (i) (ii) (iii)
       
Net rental income £180,000 £180,000 £180,000
Deduct finance costs (£90,000)   (£90,000)
Taxable profits £90,000 £180,000 £90,000
Corporation tax     £17,100
Income tax £36,000 £72,000 £23,693
Finance costs relief   (£18,000)  
Total tax liability £36,000 £54,000 £40,793
 

Many landlords have been considering incorporation because of the changes to the treatment of finance costs. However, incorporation can also lead to other benefits in the lower rates of corporation tax for profits reinvested in the property rental activity rather than drawn by the owners, and the ability to transfer ownership to future generations via the transfer or issue of shares. The latter is outside the scope of this article, but it is generally easier to transfer a share in a company than an interest in one or more properties.

Mechanics of property incorporation

Taken at its simplest level, and absent any tax considerations, property incorporation is the transfer of the beneficial ownership of the property from personal ownership to company ownership.
The transfer of an interest in land and property in the UK generally has to be in writing, and either has to express the consideration that will be given for the transfer, or has to be a gift by way of deed.
The consideration for property incorporations usually falls within one or more of the following, with tax considerations often determining the form of consideration to be received:

  1. Issue of shares

  2. Assumption of liabilities

  3. Cash, either immediately payable or left as an outstanding debt

The correct legal formalities should be followed at the time to document the transfer of the property business and the consideration to be given for the transfer, even if the latter cannot be expressed as a fixed and definitive sum until accounts are drawn up. Failure to follow the correct legal formalities can lead to problems later.

Tax considerations

Before considering the tax liabilities that might arise on the transfer of property from personal to company ownership, it is worth noting that following the transfer the rental profits will be subject to corporation tax rules as opposed to income tax rules. In addition to the lower rates of corporation tax that would apply to annual profits, legislation that only applies to companies such as the loan relationship rules would apply, and the accounts would have to be prepared on an accruals basis.

Turning to the tax liabilities that might arise on the transfer of property to a company, the two taxes that are usually of concern are capital gains tax (CGT) and stamp duty land tax (SDLT). Unless any reliefs or other reductions to the tax liabilities apply then the transfer on incorporation will be subject to CGT and SDLT based on the market value of the properties as the company will, on an incorporation, 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. The rates of SDLT for the acquisition of residential property will include the extra 3% for the purchase of additional residential properties, but on incorporation of a rental property relief from the flat rate of 15% would normally be available.

CGT incorporation relief

CGT relief on the incorporation of a business is available under s 162 TCGA 1992 (incorporation relief), and this can include a property rental business. There is 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.

A body of case law has built up around the meaning of business for a number of different taxes. This case law has stated that a number of factors need to be taken into account when determining if a business is being undertaken, rather than the mere receipt of passive rental income. Areas that can cause difficulty when being assessed against case law include the following:

  • Multiple other sources of income, including full time employment

  • Ownership of multiple businesses or companies

  • Use of a managing agent, including one connected to the property owner

  • Insufficient scale of the property rental activity

If it can be established that a property rental business is being undertaken then the operation of the relief still needs to be considered, as 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 held over. If any cash consideration is received, then the gain held over is proportionately reduced and part of the gain is immediately chargeable. The assumption of liabilities does not count as consideration.

In a highly geared property business the gain to be held over may exceed the original tax base cost of the shares, taken as the net asset value of the property business prior to incorporation. Since the tax base cost cannot be reduced below £nil, any excess is immediately chargeable.

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.

SDLT reduction

Although the rate of CGT is higher at a maximum of 28%, it only applies to the gain whereas the SDLT charge is a percentage of the market value of the property being transferred. Moreover, where multiple properties are being transferred these will be linked transactions so the higher percentages of SDLT will apply to more of the value being transferred. It is, therefore, the SDLT charge that is often the prohibitive factor when considering incorporation of a rental property business.

The overall SDLT liability can be reduced in certain circumstances. Where multiple residential properties are being transferred then a claim for multiple dwellings relief (MDR) can be made, which allows more of the consideration to be charged at the lower rates of SDLT. Where six or more residential properties are being transferred then the non-residential rates of SDLT can apply, although a comparison should always be made with a claim for MDR as in some cases this can produce a lower result.

The only circumstances where an SDLT liability otherwise arising can be reduced to £nil is on a transfer from a partnership to a connected company. The SDLT legislation applying to partnership transactions can reduce the charge to £nil. The SDLT legislation only applies if the business is undertaken in partnership.

A partnership exists where the partners carry on a business in common with a view of profit. As with the definition of business, a body of case law has built up around the meaning of partnership, with a particular focus on whether the relationship between those carrying on the business is “in common” so that they are treated as partners in a partnership. Factors taken into account include the sharing of losses, costs and liabilities and the way the partners and partnership are presented to suppliers and customers, including name or names used and clarity that partners are representing the partnership.

Final thoughts

Significant tax liabilities can arise on the transfer of rental properties to a limited company, especially if a business or partnership do not exist. These are generally matters 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.

One possible mitigation against the uncertainty of this judgement call is to consider insuring against the risk of the significant tax liabilities.

In our experience, many cases have a disjointed fact pattern which has developed over time, and where different factors may point to different conclusions. Each case needs to be reviewed based on its own facts. We are offering a free 20 minute telephone consultation to discuss your client’s fact pattern with a view to concluding whether it is worth us exploring in more detail the existence of a business or a partnership, and then preparing a detailed plan for incorporation.

To book your free consultation or for any other property queries please contact Mark Baycroft or call 0333 920 5708.

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Tagged Property tax & SDLT Property tax & SDLT COVID-19
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