The recent Stamp Duty holiday, temporarily increasing the nil rate band for residential purchases, has resulted in a further wave of property owners considering the merits of incorporating their buy-to-let portfolios.
The reason being that whilst there still will be the 3% surcharge to pay by the acquiring company on incorporation, this 3% is overlaid on the temporary nil rate band up to £500,000 (rather than the usual rate of 0% to 5%), thus potentially reducing the cost of the exercise.
However, the reduced Stamp Duty costs are but the tip of the iceberg in a property portfolio incorporation and owners still face significant tax risks, should the facts of their transaction not meet certain prescribed conditions.
This article revisits the origins of the recent trend of incorporations, outlines the tax issues of the incorporation itself, considers the tax treatment for a portfolio post incorporation and shines a light on the commercial realities of such a restructure.
The Triggers: Removal of Mortgage Interest Deductibility
Prior to April 2017, 100% of the interest payment was allowable as a straight deductible expense against a landlord’s rent, leaving only the net amount subject to tax. From 2017 onwards, this approach was phased out (over 3 years) and replaced, with a new tax credit system. Under this system, a flat credit equal to 20% of the interest cost is given. Therefore, if you are a higher or additional rate taxpayer, you end up with 20% relief as opposed to 40% to 45%. As of April 2020, this system is now fully in place (following the staged introduction), with the impact on some highly geared portfolios being that after-tax profits have been greatly reduced and in some situations portfolios have tipped into being loss making.
The solution that has been favoured by some therefore is to incorporate the portfolio, as companies can still offset 100% of the interest costs against the rent (up to £2 million of interest in any 12 month period). In addition, the rate of Corporation Tax (currently 19%) may be favourable to Income Tax at 40% to 45%, i.e. where the after Corporation Tax rental profits do not need to be extracted by way of dividend, but rather rolled up for reinvestment. In such a case, only Corporation Tax at 19% is paid in comparison to the individual’s Income Tax rate.
Incorporation Relief Itself – THE LAW
Section 162 TCGA 1992 (Taxation of Chargeable Gains Act) applies where “a person who is not a company transfers to a company a business as a going concern, together with the whole of the assets of the business or together with the whole of the assets other than cash, and the business is so transferred wholly or partly in exchange for shares issues by the company to the person transferring the business”.
Where this happens, the effect is that the capital gain that would otherwise crystallise on the disposal of these assets, is effectively rolled over into the “new” assets (i.e. the shares), with that rolled over gain not crystallising until the share asset is then sold.
The logic here is to help businesses restructure how they operate without a punitive tax liability hampering the migration.
Whilst all conditions of S162 need to be satisfied (and tax advice should be taken), in the context of property portfolio incorporations, much of the consideration has focused on the key requirement that in order to incorporate you must first have a “business”. Whether a buy-to-let portfolio amounts to a business rather than an investment asset was considered in the leading case of Ramsay, which remains the benchmark against which all portfolio owners should assess their circumstances when contemplating incorporation.
Elizabeth Moyne Ramsay v HMRC [2013] UKUT
In this case, HMRC denied S162 incorporation relief on the grounds that the 10 apartment block that was incorporated was merely a passive investment asset and not a “business”. The First Tier Tax Tribunal agreed but the decision was later overturned by the Upper Tax Tribunal (“UTT”). The case should be read in full to appreciate the nuances (Elizabeth Moyne Ramsay v HMRC [2013] UKUT), but in summary, the UTT concluded that there is no statutory definition of “a business” and whilst the activities carried out on the property in question could equally be carried out by a landlord of an investment property, the degree of activity demonstrated by Mrs Ramsay (20 hours plus per week of activities) outweighed what would be expected from even a diligent landlord and, as such in the Judge’s view, the activities amounted to “a business” and S162 Relief was permitted. The activities in question are listed in the Judgment and cover a range of maintenance and management type tasks.
CGT Risk
As is noted from the Ramsay case, the threshold for a portfolio operation to amount to a business is a very fact specific analysis, which may be open to interpretation and, indeed, dispute by HMRC.
The risk, therefore, is that should the “business” test not be met (or of course, any of the other S162 conditions), a CGT disposal will crystallise with tax at 28% being charged on the difference between the market value and the property’s base cost. Whilst various allowable expenditure needs to be considered when assessing CGT, the starting position should be to think of the acquisition price versus the market value.
For many properties bought several decades ago, the gain could be huge and so too the potential CGT bill if S162 Relief is denied.
HMRC will no longer provide a clearance in advance to confirm whether the portfolio activity meets the S162 “Business Test”, so it’s now essential that detailed tax advice be taken before incorporation.
What about SDLT?
S162 considers the position as the Transferor for CGT purposes, but what about the Transferee – the company? Regardless of CGT roll over treatment, the company is treated in SDLT terms as making an “acquisition of a chargeable interest in land”.
Where an individual portfolio owner seeks to incorporate, he/she will receive shares in the Transferee company as consideration for the transfer under S162. As a result of the shareholding, the individual and the company are “connected” in tax terms, the result being that a special SDLT rule applies, making the company liable to SDLT on the market value of the property transferred (despite no cash changing hands).
Partnerships Sidebar
[It is worth flagging that this article considers the position of an individual transferor, which has been impacted by the current Stamp Duty holiday. The SDLT position for partnership transferors (which can also benefit from S162 Relief) remains subject to the complex rules contained in Schedule 15 FA 03, as opposed to the Section 53 Market Value rule (set out above) that applies to individuals. These partnership rules can technically give rise to an incorporation which does not trigger any SDLT for the company, provided that the partners’ partnership shares pre incorporation are matched by the post incorporation shareholdings and the company is connected to those partners. Detailed analysis is however needed on a case by case basis.
Furthermore, it is important to note that contrived partnership arrangements with tax planning motives would be at high risk to HMRC challenge, with potentially significant adverse consequences. No such planning should be undertaken without proper independent tax advice. Contact info@winslows.co.uk for more information regarding this.]
Once the market value is obtained, all normal SDLT issues need to be considered:
- Is Multiple Dwellings Relief available?
- Is the portfolio a mix of residential and commercial properties?
- Does 15% higher rate apply of properties over £500,000?
- Does “6 or more” dwellings rule come into play (that can treat the transaction as commercial)?
- What about ATED (Annual Tax on Enveloped Dwellings) – has this been considered to ensure an exemption applies?
What is clear though is that unless the portfolio includes commercial or mixed use property the 3% surcharge will apply to any dwelling worth over £40,000 that isn’t subject to a lease of greater than 21 years, because the purchaser is a company.
SDLT Holiday
However (and this is what may be enticing for some owners), the 3% surcharge applies not on top of normal rates but on top of the temporary SDLT Holiday nil rate, reducing the cost for the company.
For each £500,000 dwelling acquired during the SDLT Holiday, the tax will be £15,000 as opposed to £30,000 under normal rates. So, over multiple properties, it’s understandable why some portfolio owners are giving this close consideration.
But, is it worth it?
In order to actually reach this commercial decision, it’s important to balance not just the cost of the exercise (tax and otherwise) with the potential future tax savings of incorporation (i.e. less tax on rent roll), but also whether a property portfolio held within a company best suits the client’s future objectives.
Cost versus Benefit of Exercise
The thought process should go something like this:-
- How much Income Tax is paid on the rent roll (taking account of the reduction to interest deductibility)?
- If the portfolio was owned by a corporate, how much Corporation Tax (“CT”) would be paid on the same rent roll?
- If the owner needs/wants the after CT tax profit in his or her hands, what Income Tax would then be paid on extracting that cash (salary/dividend)?
- Does the combination of the tax calculation at 2 and 3 above leave the owner better off than under the calculations at 1 above? If so, by how much?
- Will S162 apply?
- If there is any doubt, what is the CGT liability which could bite? (It may be the properties have very little gain or it may be there is a large gain accumulated over many years). Determine the number.
- What is the known SDLT liability for the company (taking account of SDLT Holiday and all applicable reliefs)?
- How many years need to pass (based on the annual saving at 4 above) before the SDLT charge at 7 above is offset?
- Weighing up the number of years at 7 above and the degree/quantum of risk at 6 above, is this a smart business decision?
If the answer is “Yes”, finally, consider future plans, in particular the potential sale of properties. If properties are now owned in a company, what are the different permeations on sale?
- Sale proceeds from the property go into the company. Are they reinvested? If they are to be extracted, how and what is the tax cost?
- Benchmark this against the tax implications of selling property from personal (non–incorporated) ownership. What suits that particular client?
As with most tax driven restructurings, every case is different and no one solution fits all.
Andrew Waddell is Managing Director at Winslows Tax Law. www.winslows.co.uk To receive SDLT updates/bulletins please click here.
