Lee Sharpe looks at the main rules that govern a taxpayer transferring rental income rights to another.
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This short article will cover the key aspects of ownership and splitting income, in terms of co-owned property. Note in particular that there are special rules for property owned between those in a married couple (or civil partnership) that can complicate matters. Note also that the rules for property ownership differ a little in Scotland, and readers should check that the rules align in the devolved territories of the UK.
Tax follows beneficial ownership
Generally, direct taxes focus on ‘beneficial ownership’ (also referred to as a person’s ‘equitable interest’ in a property) as distinct from legal ownership. While it is very common for those with legal title also to hold the equitable interest in a property, they could instead fall to different people.
I may need legal title or ownership of a property in order to formally complete a sale of a property, but the benefit of the proceeds (or of any rental income or occupation of the property before disposal) falls to the parties with the beneficial interest. If proceeds on sale or income from rents fall to the beneficial owners, it stands to reason that HMRC will focus on beneficial ownership.
As an aside, tax law permits HMRC to assess a person who receives or is entitled to receive rental income (ITTOIA 2005, s 271). However, it is generally agreed that while the statute, strictly speaking, allows HMRC to assess (say) a letting agent to income tax for their clients’ rents as the agent receives the rents, that is still on the landlords’ behalf, as the rents ultimately ‘belong’ to the latter. The obvious example would be where the letting agent is usually obliged to withhold and account for tax from rental income they have received before onward payment to a landlord who is not resident in the UK for tax purposes; the income is still ultimately chargeable on the landlord.
Taxable income shares default to respective beneficial interests
By default, income tax law will ‘assume’ that if, for example, Jill and Jack (who are not related) own a property 3:1 in Jill’s favour, then any rental incomes will be split the same way. But HMRC’s Property Income Manual also acknowledges that co-owners may decide to split their income differently and should be taxed according to the split they have chosen. They do not have to be in a partnership for this to be the case; mere co-ownership will suffice (PIM1030).
However, this is not always the end of the matter.
Anti-avoidance legislation: the ‘settlements regime’
The Property Income Manual is less forthcoming on how HMRC can, in some cases, still attack a share in annual profits that differs from the underlying beneficial ownership in the property itself. Where applicable, the settlements anti-avoidance legislation will, for income tax purposes, treat the income diverted as still ‘belonging’ to the beneficial owner (ITTOIA 2005, Pt 5, Ch 5, starting at s 619).
Example: Change of rental property profit split
Jill and Jack jointly own a small portfolio of properties but their beneficial ownership is 3:1 in favour of Jill. By default, tax law will assume that the income should be split in the same proportion (unless they are married; see below). However, Jill and Jack agree to split their rental profits 60:40, as Jack has taken on more of the day-to-day management of the portfolio.
In terms of the settlements regime, Jill’s standard entitlement has fallen from 75%: 25% down to 60%: 40%, so she has ‘settled’ 15% of the total profits in favour of Jack. IF the anti-avoidance regime bites, she will still be taxed on 75% of the rental profits, even if Jack physically takes 40% of the profits (under self-assessment, it is Jill’s responsibility to recognise when the settlements regime should apply and she is supposed to adjust her tax return accordingly).
Clearly, it is important to identify what causes the settlements regime to be triggered.
When does the settlements regime apply?
The main aim of the settlements regime is to reverse scenarios where the settlor (Jill in the above example) purports to give away income or other assets, but in some way still benefits from what has been gifted, such as:
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Jill gives away 15% of the total annual rental income to Jack, who happens to be her spouse. The regime specifically provides that Jill will still benefit from the income that is still coming to benefit her via her spouse or civil partner.
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Jill diverts 15% of the total annual rental profits to Jack, who is now her 15-year-old son. The law again presumes that the benefit of this income will effectively still fall to Jill on account of income diverted to a minor child of hers, where she is also the settlor.
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Jill has settled 15% of the total rental profits on Jack, who is not a relative, but there is an arrangement whereby (for example) Jack’s and Jill’s families all go on holiday together, and Jack pays for everything. Jill, or her spouse or her young children will stand to benefit indirectly from the slice of annual rental profits she has settled on Jack.
Further points:
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Readers may be aware that, at 15 years of age, Jack cannot directly own an interest in property. Let us say that there was a bare trust in Jack’s favour to hold Jack’s interest in the property portfolio until he reaches 18.
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The settlements tax legislation specifically targets arrangements where the settlor’s spouse or civil partner or the settlor’s minor children may benefit from the thing being given away instead of the spouse directly. But it is also drafted to catch scenarios, more generally, where the settlor will or may benefit from what they have given away. Even so, in the absence of such circuitous or reciprocal arrangements, there may still be a settlement of income according to general law, but the anti-avoidance tax regime can then bite only if the settlor, their spouse or civil partner, or their minor children may benefit.
So far, so straightforward, relatively speaking. But there are further potential complications to keep in mind.
Property held jointly between spouses
Considering the very common scenarios where spouses or civil partners hold property as co-owners:
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There is provision within the settlements regime itself that protects certain settlements between spouses or civil partners from having their incomes re-allocated for tax purposes by the settlements regime. But the ‘spouse exemption’ will not apply where the gift is solely of income. Simply put, the spousal exemption applies where the income reflects a transfer of the ownership in the underlying asset. Just re-allocating profits away from the underlying beneficial ownership will not benefit from that spouse exemption.
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Where the property is held only by spouses, etc., in joint names, in the vast majority of cases rents will have to be split either:
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50:50; or
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directly and only according to the underlying beneficial ownership held by each spouse or civil partner – and this only when the couple have made a valid joint notification to HMRC to replace the standard 50:50 apportionment.
The main exception to this 50:50 straitjacket for property held in joint names is where the couple is operating in partnership proper.
Conclusion
So far, the foregoing could be summarised very broadly as ‘you may split the rents from co-owned property as you like, so long as the split is genuine, and you don’t fall foul of any of the ‘simplifications’ in the tax regime supposedly to help married couples and civil partnerships’.
Further potential issues include whether the arrangement will qualify as a ‘proper’ partnership, the form of ownership (joint tenancy or tenants in common), and potentially even whether or not there has been a ‘transfer of an income stream’. And it is understood that Scottish law does not recognise the conceptual split between legal and beneficial ownership in the same manner as English law. As usual, it is recommended that competent advice be sought, in contemplation of moving away from the default split according to underlying beneficial ownership.
