Alan Pink looks below the surface of some strange business arrangements, and points to some possible unintended consequences of partnership changes.
Buy-to-let (BTL) ‘partnerships’ are probably at the peak of their popularity at the moment. In some ways this is surprising, for reasons we will come on to discuss.
What’s the point?
The basic point of running your BTL property portfolio as a ‘partnership’ (commonly a partnership between husband and wife), rather than simply sending in tax returns showing half of the income each as income from land and property on your tax returns, is reasonably clear.
Landlords generally are still waking up gradually to the realisation of what a horrific impact the so called ‘Osborne tax’ is having on their liabilities. In many cases, which we have come across in the real world recently, landlords are facing a tax rate of more than 100%, as a result of the disallowance of mortgage interest on BTL property portfolios for higher rate income tax purposes.
Those who don’t want simply to sit back and suffer the impact of these much increased effective rates of tax on rental profit are looking at restructuring their affairs in order to sidestep this tax imposition. Undoubtedly, the most popular way of doing this is to incorporate your BTL property portfolio into a limited company (although the wisdom of this is something that can be questioned, in my view).
The key point is that in order to avoid paying stamp duty land tax (SDLT) (or equivalent, in Scotland and Wales) on moving your property portfolio into a limited company, you need to show that the transfer is coming from a ‘partnership’ into a limited company which it has the requisite form of connection with the partners.
Is there a ‘partnership’?
In many cases, a joint ownership situation has been returned to HMRC as a ‘partnership’ for a number of years; but are all of these joint ownership situations real partnerships?
It’s very important to note that the fact HMRC has apparently accepted these partnership tax returns, showing nothing but rental income, is not necessarily a gold plated endorsement by HMRC of the accountants’ treatment of these numbers in practice.
Whether you show the income on a partnership set of accounts, and set of supplementary tax return pages, or whether on the other hand you show the relevant fraction of the profits on each individual’s tax return as income from land and property, the amount of tax chargeable is exactly the same. So nothing hangs on the question of whether you have a partnership or simply joint ownership. Until, that is, the property portfolio is transferred to a connected company, when the question becomes highly relevant for SDLT purposes.
So what do we mean by talking about uncertainty as to whether these partnerships actually exist, or not?
The question is highly relevant not just for SDLT purposes, but also for income tax and capital gains tax (CGT) purposes. If someone is brought into ‘partnership’ in a purely property investment business, or leaves that partnership, there could be CGT implications, of which more later on. But also it is hard to see, if there is no ‘partnership’ as such, how a person who has not necessarily been brought into full joint ownership of the relevant properties can validly be given a share of the income from those properties for tax purposes. The fact that HMRC may have accepted such an allocation of income that does not coincide with legal ownership per the Land Registry is not necessarily conclusive, and does not necessarily stop some bright spark of an HMRC Officer from challenging the situation.
What is a partnership?
A partnership is defined, in a well-established and venerable form of words, as the ‘relationship which exists between persons carrying on a business in common with a view to profit’ (Partnership Act 1890).
The first point to make about this is that it is a definition for the purposes of the Partnership Act 1890, and isn’t necessarily determinative for tax purposes. What this definition tells us is that there needs to be some kind of ‘business’ for a partnership to exist. You cannot simply (for example) own your own home with your spouse in a partnership, if that partnership does nothing else.
A partnership is not a legal entity, at least under English Law. It is a ‘relationship’, which is an abstract concept rather than an entity in itself. There is no controversy (as far as I am aware) that a partnership may receive investment income.
For example, a firm of solicitors may sublet part of their offices to an unconnected business and receive rent, which enters the partnership accounts and is shared out amongst the partners. But we would suggest that the situation is uncontroversial where the firm is also conducting some kind of trade or profession. But is there a partnership if there is no trade?
The relevance of the question: Does a partnership exist?
We’ve already mentioned the situation where a property portfolio is transferred to a limited company. If one moves from a simple joint ownership situation where there is no partnership to a limited company, SDLT would be chargeable, and at current rates of tax this could be a very substantial sum.
However, there are also many other key tax questions that depend on whether there is a partnership, including the question of whether income can be allocated unequally, and allocated partly to persons who are not actually registered as owners of the property in question at the Land Registry.
Limited liability partnerships
It is here that limited liability partnerships (LLPs) become highly relevant. An LLP is treated under tax law as if it were a partnership, and this is a statutory fiction which applies to all kinds of business activity, including investment activity.
Accordingly, if you want to be absolutely sure that your BTL property portfolio is run as a partnership and will be treated as a partnership for all tax purposes, including SDLT, CGT, and income tax, one way to bring about this situation may well be transferring the portfolio to an LLP.
Partnership changes
However, one of the main purposes of looking at this whole question is to consider the possibly unintended consequences of partnership changes, where you have a BTL property partnership.
Let’s look at an example situation which highlights both the income tax opportunity and the CGT pitfall.
Example: Family BTL property ‘partnership’
Mr and Mrs Ordinary own a property portfolio worth £1 million currently, the properties in which cost them £400,000 some years ago. Both are higher rate taxpayers because of their overall income situation, and so they decide to bring in their son Norman as a partner in their BTL property ‘partnership’. Accordingly, in the next year’s tax return, the income from the portfolio is split three ways, rather than two ways, and Norman’s otherwise unused personal allowance is offset against his share of the rents, with the result that the overall tax on the rents which the household bears is significantly reduced. Result.
However, there is a sting in the tail. If it is a partnership, in the absence of any specific agreement to the contrary, Norman is treated as coming in with a one-third interest in all the properties in the portfolio, and consequently his parents are treated as making a disposal of one-third, for market value. Tax therefore falls due on a deemed capital gain of £200,000.
This seems like a bad idea, especially given that things could have been arranged in such a way as to avoid any such disposal; under the terms of the HMRC Statement of Practice relating to the capital gains of partnerships, Norman could have been given a much lesser share in capital profits (and therefore deemed share of ownership of the properties), and consequently the CGT bill could have been much less.
Remember, this is all on the basis that HMRC accepts that there is a partnership. If they do not, the income purportedly allocated to Norman, and taxed on him, could instead be reallocated by HMRC to the parents.
Practical tip
I would suggest that you don’t rely on the current woolly state of HMRC practice. Instead, if you want to allocate income differently than purely equally between joint owners, consider bringing the property portfolio into an LLP; take special care over the capital profit sharing entitlements under the LLP agreement, where you bring in new partners or some partners leave. By arranging these correctly, you can avoid any taxable disposal taking place in most circumstances.
