Many readers will be aware of measures announced in the 2015 summer Budget, which will phase in the disallowance of mortgage interest (and related finance costs) for residential property businesses over the next few years.
These measures apply only for income tax purposes, and companies are specifically excluded from the measures (by and large, except where acting in a fiduciary or similar capacity). It seems likely that a substantial number of property investors will look to incorporation as a potential solution.
Health warning!
There is far more to incorporating a business than trying to avoid a hefty tax rise. Companies are separate legal entities and, like the directors who run them, are bound by legislation, such as the Companies Act 2006. The assets transferred to the company, and the profits it generates, belong principally to the company, and only indirectly to the shareholder(s) who owns the company. Tailored professional advice is absolutely essential when contemplating a transaction at this level.
Tax considerations
There are numerous issues to consider on transferring a property investment business to a company, including:
1. capital gains tax;
2. stamp duty land tax (or land and buildings transaction tax in Scotland);
3. VAT – if there are any commercial properties; and
4. capital allowances.
We shall look at each of these in turn.
Capital gains tax
A mature property investment business is likely to be worth much more than it originally cost to acquire and develop.
Many people assume – incorrectly – that there is no capital gains tax (CGT) to pay if you give assets away and no money changes hands. Basically, CGT is due on the market value of an asset transferred by way of discount or outright gift, no less than if full consideration were received. There are exceptions, such as most transfers between spouses/civil partners, and gifts of trading assets, but these are unlikely to be relevant to a property business.
In the absence of any reliefs, a CGT charge is in point, on transferring a property investment business into a limited company. Fortunately, a relatively recent tax case (Ramsay v Revenue & Customs [2013] UKUT 0226 (TCC)) found in the taxpayer’s favour when she incorporated her business and claimed incorporation relief.
CGT incorporation relief
This relief broadly applies to postpone the capital gain that arises when a person transfers chargeable assets into a company, in return for the issue of shares in that company. It is important to note that:
- it is essentially an ‘all or nothing’ transfer: all of the business assets must be transferred into the company; one cannot pick and choose which assets are transferred; and
- the relief applies to the extent that it is only shares which are issued in exchange for the property transferred; other consideration will result in at least part of the gain becoming taxable.
The net result of this relief is that the gain which would otherwise have been taxed on incorporation becomes ‘embedded’ in the shares now held in the company, until they are sold or otherwise disposed of. Of course, if there is no intention to sell the shares, the gain is postponed indefinitely.
One important point about incorporation relief is that it is by no means certain that a property business will qualify for the relief. While the Ramsay case confirmed that a property business might qualify, it would be wrong to assume that all property businesses will qualify. Critically, Mrs Ramsay was able to demonstrate that she actively participated in running a property business. For many property investors, their activity is a full-time occupation; others may, for instance, delegate day-to-day running to a letting agent, which might prove problematic. It may be possible to check with HMRC if they think that a particular property business is eligible or not. See HMRC’s Capital Gains manual at CG65700.
Stamp duty land tax
Generally, where a property is transferred as a gift, it may avoid stamp duty land tax (SDLT). Unfortunately, there are provisions in the SDLT regime that result in a charge based on market value when property is transferred to a company under the control of the transferor. Having said that, there are also provisions that allow partners in a normal ‘general’ partnership (or a limited liability partnership) to transfer property to a connected company without an SDLT charge.
While a partnership might at first seem to offer a relatively simple route to avoiding the potential SDLT charge on incorporation, a jointly owned property investment business is, in the eyes of the taxman, no more a partnership than a jointly-held bank account. This is arguably quite unfair to joint owners who might actively work together to run a property business, but the legislation and HMRC’s interpretation are quite unhelpful in this regard – see for instance HMRC’s Property Income manual at PIM1030.
Even so, it may be possible for jointly owned rental businesses to demonstrate the degree of commercial organisation required in order to ‘qualify’ as a partnership. Limited liability partnerships have the potential to force the issue in favour of the taxpayer, although anti-avoidance legislation can be triggered where it seems to HMRC that a partnership (or LLP) has been created in order to avoid an SDLT charge, rather than for genuine commercial reasons. Two further points about SDLT:
- it may be beneficial to consider a claim for ‘multiple dwellings relief’, to derive an SDLT charge based on the ‘average’ market value; and
- when transferring six or more properties, it may be advantageous to apply the ‘non-residential use’ SDLT rates, which are capped at 4%, rather than the maximum 12% for residential properties in a lettings business.
VAT
Aside from short-term letting such as hotels and holiday lettings, renting out residential property is exempt from VAT, so the transfer to a limited company should not trigger a VAT charge. Care is needed, however, where commercial property is transferred alongside; such a disposal may be subject to VAT, and there may also be implications for having opted to tax the property(ies), the business’ partial exemption position and the capital goods scheme may also be in point.
However, VAT may be avoided because a ‘transfer of a going concern’ is outside the scope of VAT (which will help reduce SDLT as well, since it is calculated inclusive of VAT). Even if the incorporation does escape a VAT charge, a new registration/change of entity may have to be notified to HMRC. Remember that if you want to claim CGT incorporation relief, you may have no choice but to transfer commercial property alongside residential – all of the business should be transferred.
Capital allowances
This is again particularly relevant for commercial properties, where allowances may have been claimed in the current business. Incorporation will cease the original property business for the purposes of capital allowances, and by default a balancing event will arise, although it should normally be possible to make a joint election to transfer at the prevailing written down value to avoid a charge.
It may, in some cases, be possible to reduce the proceeds even further and generate further tax allowances. This will be particularly beneficial where the original owners are subject to 40% income tax, but the company will pay only 20% corporation tax; taking the relief before incorporation would save 40% rather than just 20% later on in the company. It is also important to note that a joint election (and asset pooling where appropriate) will be required in order for the company – and any subsequent buyer – to be able to claim capital allowances on any fixtures in the property at the point of transfer.
Practical Tip:
There are numerous tax aspects to incorporating a business. It is also important to understand that it is not necessarily easy to disincorporate, should the need arise later. As mentioned at the outset, tailored advice is essential.
Next Steps
If you are considering incorporating your property business and would like to discuss your situation with Lee Sharpe, then click the link to book a tax consultation with Lee.
