Alan Pink looks at tax problems with making partial realisations of value from family property companies, and how to mitigate those problems.
The family property holding company has always been a popular business structure, and for various reasons (including the ‘Section 24’ iinterest disallowance) seems likely to become ever more popular - whether deservedly or not.
Unlike the situation where property is simply held direct by individuals, property investment companies can give rise to much head scratching when it comes to a particular need to realise funds from out of that company, as the following examples will illustrate.
What’s the problem?
Put in crude terms, once you hold a property portfolio through a limited company, it isn’t ‘yours’ in the same sense as if you owned the property direct. Any attempt to access the value locked up within the company will always face two potentially major tax charges:
- Income tax on the individual, on receiving value out of the company (most frequently in the form of dividends); and
- Capital gains taxation within the company on the disposal of property – either by direct transfer to an individual shareholder, or by way of sale in order to raise the funds to pass out to the shareholder.
In some circumstances, stamp duty land tax (SDLT) (or equivalent in Scotland and Wales) can be a problematical element in the planning as well.
Rather than talking in generalities, though, hopefully it will be helpful to look at some practical scenarios, all based on real life situations.
Example 1: Distribution of property to shareholder
Dickens Estates Ltd is a long-established property investment company, originally owned by a single individual, but which has passed down two or three generations and is now held by the members of a number of different nuclear families; that is by cousins. Andrew owns 5% of the shares, corresponding to underlying properties worth £1 million.
The properties are in London, and Andrew’s circumstances change such that he needs to live in that city. It just so happens that Dickens Estates Ltd owns an ideal property, worth about £1 million, that Andrew fancies very much the idea of living in.
That’s fine then, you might think. Andrew can move into that property and live there rent-free, because he owns shares in the company that owns it. However, there are two major tax issues with this simple plan.
Firstly, living in a company-owned property gives rise to a taxable benefit-in-kind annually, based on the value of the accommodation provided by the company to Andrew. Secondly, a more recent enemy of this sort of arrangement is the annual tax on enveloped dwellings. This applies wherever companies (and partnerships involving companies) own property which is not either development property or let to unconnected third parties. A substantial annual charge, in addition to the benefit-in-kind income tax (and National Insurance contributions) would arise on the company.
It’s also the case, of course, that a potential tax exemption is being lost if Andrew simply lives in the company-owned property. Whereas someone who owns a property themselves and occupies it as their main residence qualifies thereby for capital gains tax exemption on the sale of the property, the company itself, as owner, will never qualify.
In order to get around this, ‘Plan B’ is devised by the family. The company will pay a dividend to its shareholders, and Andrew’s share of this will be sufficient for him to put down as a ‘deposit’ to buy the property from Dickens Estates Ltd. The rest he will raise by a mortgage from a high street lender.
But then the disadvantages of Plan B start becoming apparent. The dividend will give rise to tax on all the shareholders, not all of whom need the money and many of whom object to triggering an unnecessary extra income tax liability in this way. The company itself will have tax to pay, because it will be realising a capital gain on selling the property to Andrew. And there will also be SDLT payable by Andrew, on the £1 million purchase price.
So, in conjunction with the company’s tax advisers, ‘Plan C’ is devised. First of all, the shareholders all get together and agree that the property Andrew wants is worth about the same as his 5% share of the company (ignoring any discounting for a minority shareholding, which isn’t appropriate in these circumstances). Then the company resolves to alter the share rights, so that a single distribution can be made to Andrew, against his shares, in the form of a distribution of the relevant property to him in kind. The effect is that his shares in the company are cancelled, but he receives a distribution of the property he wants.
At first sight, a major disadvantage of Plan C, as compared with either of the other arrangements, is that Andrew has an income tax liability on the value of the distribution; which will largely be at a rate of 38.1%. However, this can be funded by way of a much smaller loan taken out by Andrew on the security of the property itself, and it arguably is only realising a deferred tax bill, that would have arisen ultimately in any event (there is no simple way of looking at this particular point). Because the property is distributed to him rather than being bought by him, SDLT doesn’t arise. The capital gain payable by the company is the same as it would have been on the Plan B scenario.
Sometimes shareholders merely want to realise some of the value of their property company in cash terms (e.g. to meet some kind of personal liability, or to improve their home). What is all the value locked in the limited company for, at the end of the day, except to benefit the family members who are shareholders? The next scenario has a look at some options for doing this.
Example 2: Asset rich, cash poor
Betty and her husband own all the shares in Bronte Properties Ltd, which has a reasonable sized property portfolio. The one thing it hasn’t got is much cash, which is a problem because Betty wants £500,000 to give to her three children, to set them on the first rung of the property ladder. So it’s going to be necessary to realise cash somehow on the back of the company’s property portfolio.
One option would be for the company to sell a property and then distribute the cash to Betty and her husband. From a tax point of view this triggers a capital gain in the company of course, and also income tax on Betty as an individual on receiving the dividend.
An alternative method of achieving effectively the same result would be for the company to distribute the property to Betty, as a distribution in kind, and for her then to sell it. The tax would be broadly the same under this scenario, with the company being treated as a realising a capital gain on making the distribution of the property to Betty, and Betty being chargeable to income tax on the value of the dividend in kind.
A third option might be for the company to raise further funds on its portfolio (which is currently unencumbered) and distribute those funds to Betty as a cash dividend. Here the tax position is better of course, because the company has not sold a property and has no corporation tax to pay on chargeable gains.
As a further possible ‘refinement’ to this idea, the company could even loan the funds to Betty. This would give rise to ‘loans to participators’ tax at 32.5%. However, the overall tax payable is likely to be considerably less than would be paid if Betty received a dividend.
Finally, a brief example of how cash funds can be realised out of someone’s pension fund:
Example 3: Sale of property to a pension fund
Ouida Property Investment Ltd has a mixed portfolio of commercial and residential properties. Its main shareholder, Charles, also has a self-invested personal pension (SIPP), which has substantial liquid funds, of about £600,000.
Charles is not seeing any very exciting investment returns on this SIPP, and is much more keen on seeing his pension invested in the solid value of bricks and mortar. So the SIPP enters into an agreement with the company to buy one of its commercial properties in Birmingham.
Whilst this transaction triggers SDLT, some of the gains tax that would have arisen can be offset by way of a contribution back into the pension scheme. The balance of cash can then be made available to Charles personally, if he so wishes, by way of a dividend distribution or, if he has a director’s loan account credit with a company, by way of a repayment of the director’s loan.
