Incorporation Of A Property Business: The $64,000 Question

Alan Pink looks at the all-important definition of ‘business’ in relation to the incorporation of a property portfolio in a limited company.

The old joke has it that the peak of an accountant or tax adviser’s ambition is to have a loophole named after him. The equivalent, presumably, for Chancellors of the Exchequer is to have a tax named after them, and the somewhat ironic label of ‘Osborne tax’ has certainly conferred this ‘honour’ on Mr Hammond’s predecessor. 

Otherwise known as ‘Clause 24’ in some circles, this new ‘tax’, of course, is actually an effective increase in income tax on many buy-to-let landlords. Where loans have been taken out to finance the acquisition of the portfolio, relief is no longer fully available against income tax. In the current year, only 50% of your interest will be allowed, effectively, when computing your 40% or 45% liability (if applicable), with that percentage going down to 25% next year, and zero percent forever afterwards. 

The property-owning community soon worked out that this was a problem which only afflicted property businesses owned by individuals. Where the properties were in limited companies, there’s no restriction of interest relief – for the simple reason that companies don’t pay income tax and have only one, flat level of corporation tax. Hence, the widespread rush to transfer property portfolios to limited companies. 

Limited companies, of course, aren’t necessarily the only way of avoiding the potentially crippling effects of the Osborne tax: limited liability partnerships (with or without company partners) have also been suggested as a way out. But transferring your portfolio to a limited company does seem to be the most popular and commonly recommended escape route. 

Needless to say, there are all kinds of hurdles to get over in transferring a property portfolio to a company. One of these is the fact that, if you do things in a straightforward way, you will also need to get the mortgage lender on board and persuade him to refinance the properties in the name of the limited company. This can be both vexatious and expensive, and the suggestion is sometimes made that you can get over this particular hurdle, or rather get around it, by leaving the legal ownership of the property the same and executing a deed of bare trust in favour of the company.

But in addition to the financing problem, there are two large tax issues to face. One of these is stamp duty land tax (SDLT) (for properties in England), and the promoters of the incorporation option consider that they have a way round that, by ensuring that the property is being transferred from a ‘partnership’ to the company. But that’s not the issue I’m going to concentrate on here. Instead, I am going to look at the potentially even bigger problem of a capital gains tax (CGT) charge potentially arising when you transfer your properties to the limited company. 

The basic rule is that a transfer to a connected company, like any other connected person, is treated as if it were a sale of the asset(s) concerned for their current open market value. So, prima facie, there is the risk of a ‘dry’ tax charge where you are treated as having made a gain even though there is no actual money around to pay the tax.

Fortunately, when CGT was first thought of, the problem of tax arising on incorporating a business in a limited company was foreseen, and ‘incorporation relief’ was introduced (now in TCGA 1992, s 162). This relief was really introduced to help people who wanted to incorporate their sole trader or partnership business into companies for commercial reasons, one of which is securing limited liability and the consequent ability to expand without fear of personal ruin. However, the relief applies wherever a ‘business’, together with all the assets of the business or all the assets other than cash, are transferred to a company as a going concern, and the company issues shares to the transferor in return. It’s a highly specific relief, which only applies in business for share transactions.

So, this is where all the pressure on the meaning of the word ‘business’ comes in. In their typically helpful way, those drafting the statutory rules providing for incorporation relief didn’t bother to include a definition of what a business was, and so this arguably vague word is left up to individual interpretation. 

In the context of VAT, any letting of property at all is regarded as a business and, therefore, potentially within the scope of VAT (although this does not apply to letting of residential properties, of course). But the difference is that, with VAT, defining business very widely is something which might give the government more tax. Where it’s a matter of granting a relief, they suddenly get much cagier! 

One can imagine a spectrum of property-related activities, with at one end of the spectrum an old lady who receives rental income from a single flat, which is managed for her by someone else, and all she does is see the rent payments being credited to her bank account. At the other end of the spectrum, you have a portfolio of several hundred or even several thousand properties, managed professionally through a central HQ office, which employs dozens of staff. Experience tells me that the old lady would not be regarded by HMRC as carrying on a ‘business’ for the purposes of incorporation relief. The buzzing office, with people rushing around holding bits of paper, on the other hand, clearly is a ‘business’. 

Naturally a sensible approach to determining this question, in cases which are at neither end of the spectrum, is to consider what views HMRC have on the issue. The first port of call here is to read what they say in their Capital Gains manual, at CG65715. 

They start off by making the point that the word ‘business’ is a wider term than the term ‘trade’. This is very informative for property investors, of course, because property investing is not generally regarded as being a trading activity. However, it isn’t necessary to be trading to qualify as a ‘business’.

Echoing my comments above about the extremely useful (not!) lack of a definition of the word ‘business’ in the legislation, HMRC make the point that ‘it is a question of fact whether a particular activity constitutes a business. It is not easy to draw the line, and each case must be judged on its own facts.’ Thank you very much! 

The meaning of ‘business’ has some recent case law precedent, in the Upper Tribunal’s decision in Elisabeth Moyne Ramsay v HMRC [2013] UKUT 226 (TCC). The relevant factors, according to the judgment in this case, are the following:

I think that most of these bullets will clearly be satisfied (if you satisfy bullets?) in the case of a let property portfolio. There will normally be substance in terms of turnover, that is the rent, and letting a property to a third party is certainly a ‘serious undertaking’ – increasingly so with the ever-rolling wave of new regulations which landlords have to comply with. Generally, there is no danger of confusing the letting of a buy-to-let property with any kind of hobby or spare time occupation.

However, the big issue is the extent of the activities, as the HMRC manual points out. In the Ramsay case, the lady concerned was found to have worked on the property for about twenty hours a week, and this was found to be sufficient to indicate the carrying on of a business. So, HMRC’s conclusion from this is that incorporation relief will certainly be available where a person spends at least twenty hours a week on the property letting. This is obviously extremely useful for those whose activities are on this sort of level.

It isn’t necessarily the case, though, that somebody whose property letting activities take less than twenty hours a week is not carrying on a business. However, you will find that HMRC will not automatically accept this to be the case. So, we are back in the grey area for anyone who isn’t a full-time or near full-time landlord.

The problem is that it is such an ‘all or nothing’ question. If you transfer your property portfolio to a company, and you find that it isn’t a ‘business’ as defined (or not defined) in the legislation, you will find yourself with a huge ‘dry’ CGT bill. It is too late to undo the transaction by the time you find out what its tax consequences are.

That’s why it was so useful that HMRC were in the habit of giving pre-transaction clearances on this very question. Unfortunately, you’ll gather from the tell-tale use of the past tense in that sentence that they no longer do so. Or, so I have been informed, where a recent application for clearance was made and we were told that, because of the huge number of such applications at the current time (I wonder why?) HMRC no longer have the manpower to give clearances.

For most people who are in the dangerous grey area, it is therefore a case of a calculated risk. If the CGT charge would be completely unmanageable (which often it would) they have no real option but to leave things as they are and leave the property portfolio outside the company – or look for alternative ways of minimising the impact of the Osborne tax which don’t involve this very tricky question of interpretation.