Sarah Bradford warns landlords to avoid a scheme designed to avoid tax, which has been the subject of an HMRC ‘spotlight’.
HMRC has recently published a ‘spotlight’ (Spotlight 63) which draws attention to a scheme used by Individual landlords in a bid to avoid tax on their property income and to reduce their exposure to inheritance tax (IHT) and capital gains tax (CGT).
HMRC warns that the scheme does not work, and the arrangements are caught by existing tax legislation.
What is the scheme supposed to achieve?
The scheme claims that by using a hybrid business model, landlords can:
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escape the rules restricting mortgage interest relief for unincorporated landlords letting residential property, securing increased deductions for mortgage interest relief;
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reduce the tax payable on the profits of the property income business;
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reduce CGT payable on any gain when the property is sold; and
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reduce the IHT payable on the landlord’s death.
Nature of the arrangements
The arrangements are based on the landlord or joint owners of the property transferring their property to a limited liability partnership (LLP) with a corporate member. The LLP allocates profits to members on a discretionary basis.
An LLP is a body corporate under the Limited Liability Partnership Act 2000. An LLP benefits from the flexibilities available to partnerships, with the added advantage of limited liability for members.
Under the scheme:
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the individual landlord or their family members (or both) sets up a limited company;
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the individual landlord sets up an LLP alongside the limited company, which is considered to be the corporate member of the LLP;
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the individual landlord transfers their properties to the LLP;
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the members of the LLP (comprising the individual landlord and the corporate member) allocate the profits of the LLP on a discretionary basis, ensuring that the individual members remain basic rate taxpayers and the remaining profits are allocated to the corporate member;
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the corporate member claims a deduction for any mortgage interest and finance costs.
Perceived tax advantages
Promoters of the scheme claim that landlords who enter into this arrangement can reduce the amount of tax that they pay. However, HMRC disputes the claims.
(a) Transfer of the asset to the partnership
The first claim is that there is no upfront tax cost in respect of transferring the properties to the LLP and that the base cost of the property is uplifted to their market value at the tax of the transfer.
However, the specific legislation (in TCGA 1992, s 59A) applies where an LLP is carrying on a trade or a business with a view to profit. The partnership is transparent for tax purposes and any dealings by the LLP are treated as dealings by the individual member. The effect of this is that each member has a fractional share of the assets of the LLP, rather than an interest in the LLP itself. Any disposal of an asset by the LLP and any gain arises on the members, with the result that it is the members who are liable for the CGT or corporation tax on their share of the gain rather than the LLP as the entity being liable for the tax on the gain.
A disposal may arise when the individual landlord transfers a property to the LLP if, as a result, their fractional share in the property is reduced.
For example, if a landlord is the sole owner of a property and transfers the property to an LLP in which they have a 50% share of the assets, the landlord has effectively disposed of a 50% share in the asset. They have transferred the whole property to the partnership but retained a 50% share by virtue of their interest in the partnership. The gain accruing to them at that time is the share passed to other partners.
Assume that at the time of the transfer, the property had a market value of £500,000 and originally cost £300,000. The landlord would retain a 50% interest by virtue of their interest in the partnership asset, disposing of a 50% share to the other partners. The disposal consideration would be £250,000 (50% of £500,000) and the acquisition cost of the 50% share would be £150,000, resulting in a gain of £150,000.
The landlord’s base cost of their 50% share would remain at £150,000, whereas the base cost of the other 50% share would be equivalent to the disposal consideration on the transfer to the LLP, in this case £250,000. Thus, the total base cost to the partnership is £400,000, rather than the market value at the date of transfer of £500,000.
(b) Allocation of profits between individual members and the corporate member
The scheme claims that by using a discretionary profit share arrangement, it is possible to secure further tax savings. To prevent individual landlords from being impacted by the interest rate restriction, the profits of the LLP are allocated so that the individual partners remain basic-rate taxpayers, with any remaining profits being allocated to the corporate member. As the interest rate restriction does not apply to companies, the corporate member is able to deduct its share of the interest and finance costs. Finally, the profits of the corporate members are taxed at the lower corporation tax rates, rather than at the higher and additional rates of income tax.
However, this overlooks the fact that anti-avoidance provisions exist to circumvent arrangements, one of the main purposes of which is to ensure that an amount is included in the non-individual member’s (such as a corporate member) share is subject to corporation tax rather than income tax. The legislation (in ITTOIA 2005, s 850C) bites where the partnership has a taxable profit, a share of that profit is allocated to a non-individual member, and one of two conditions is met.
The first condition is that it is reasonable to suppose that amounts representing the individual’s deferred profit are included in the non-individual partner’s share, and as a result both the individual’s share and the relevant taxable amount are lower than they otherwise would have been. The second condition is that: the non-individual’s profit share exceeds the notional profit allocation; the individual has the power to enjoy the non-individual member’s share (e.g., as a shareholder of the corporate member); it is reasonable to assume that the whole or part of any of the non-individual member’s share is attributable to the power to enjoy it; and both the individual’s profit share and the relevant tax are lower than they would have been had the individual not been in a position to enjoy the non-individual member’s share.
Where this anti-avoidance rule applies, the profits are reallocated to increase the individual member’s share of the profits, removing the tax advantages of allocating the profits to the corporate member. Detailed guidance on the operation of the provisions can be found in HMRC’s Partnership Manual at PM216000 and following.
Further anti-avoidance rules deal with disposals of income streams through partnerships (ITA 2007, s 809AAZA).
(c) Inheritance tax
The scheme promoters also claim that the arrangements will reduce the inheritance tax payable on the landlord’s death.
However, a property rental business is likely to fall within the exclusions from business property relief, as it would constitute the making or holding of investments. Using a hybrid business model would not change this.
Action points
HMRC advises landlords who may have become involved in the scheme to withdraw from it and to settle their tax affairs. They should contact HMRC to make a disclosure. They may want to take independent professional advice.
Scheme promoters must comply with the disclosure of tax avoidance scheme (DOTAS) legislation and ensure they advise HMRC of any arrangements they are marketing. Promoters are liable to penalties if they fail to disclose a scheme which falls within the scope of the DOTAS legislation. Penalties are severe, with initial penalties of up to £600 per day and possible penalties of up to £1m.
Practical tip
Landlords should exercise extreme caution in relation to complicated schemes which promise to save tax. Rather than saving tax, the landlord may find that participation in the scheme costs them more, as they may have to pay interest and penalties on top of the tax they sought to avoid, plus fees to the promoters of the scheme. It is advisable to take independent professional advice before signing up to a scheme.
