It is quite often the case that when individuals invest in second properties, at least part of the purchase price is raised through a mortgage. As a result, obtaining tax relief for the interest costs of the mortgage tends to be a key part of the financial equation for these investors. Of all the taxation changes in recent years, the phased introduction of finance costs relief restriction in 2017 has been the most worrying for private residential landlords. Some highly geared property businesses that are currently healthy and profitable could suffer tax charges in excess of their profits once the restrictions are fully operational from April 2020 onwards.
One way forward that is increasingly being looked at by landlords is the possibility of putting their properties into a limited company set up (incorporating). This is because the interest restriction does not apply to limited companies running a property business and it does therefore offer a way to mitigate or avoid the effects of the rule change.
However, incorporating a property business is not as straightforward as may sometimes be claimed and there are some very important tax consequences that may arise on transferring properties into a limited company that need to be fully understood and considered before going down this road. These are discussed in this article
Incorporation is simply the process by which a business owned and run by an individual or a partnership is transferred into a company structure. Because a company in law is a separate legal person from its owners, the transfer of the business and/or properties from an individual to a company is more or less the same as if they were being transferred from one individual to another. As a result there will be a degree of formality involved which need the help of a suitably qualified solicitor.
In most cases, the business will be transferred to the limited company in exchange for shares and will probably not involve the transfer of any cash. Nevertheless from a HMRC perspective, the transaction will be treated as having taken place at market value and will therefore give rise to two important tax consequences :-
- Firstly, the transfer will be subject to Stamp Duty Land Tax (SDLT) at the prevailing rates on the value of the property transferred
- Secondly, the transfer of the property may result in a chargeable gain which will be liable to Capital Gains Tax (CGT)
Stamp Duty Land Tax (SDLT)
Unless the business being incorporated is a partnership, SDLT will be payable by the company on the market value of the property that is transferred to it on incorporation, using the market value at the date of transfer – regardless of whether any actual consideration is received or not. The SDLT scale charges will include the supplemental 3% charge. This means that even though the current base rate of SDLT on properties valued at upto £500k is nil until the end of June 2021, the 3% will still be payable regardless.
Where the properties are held in a partnership it may be possible to transfer them without giving rise to an SDLT charge at all. If the existing business is a partnership (as evidenced by a partnership agreement and the submission of partnership tax returns to HMRC) and all partners receive shares in the new company in identical proportions to that which their partnership share entitled them to, then relief from SDLT should be available. However, co-owners who seek to establish a partnership with the intention of claiming relief on subsequent incorporation may face a challenge from HMRC. There are strict anti-avoidance provisions to deal with any abuse and so it is not possible to notionally create a partnership prior to incorporation to avoid the SDLT charge.
It should also be noted that it is not possible to withdraw capital from a partnership within three years of land or property being added to it, otherwise there is a clawback of any SDLT relief that was claimed on incorporation.
For non-partnership businesses, some relief from SDLT may be available if at least two dwellings (excluding any with a value of £500,000 or more) are transferred in a single transaction or linked transactions by electing for multiple dwellings relief, which will entitle the company to calculate the SDLT charge on the average consideration of each property. If six or more dwellings are transferred in a single transaction, the non-residential rates of SDLT may apply. However, the non-residential rates of SDLT will not apply to any of those dwellings that are worth more than £500,000.
Capital Gains Tax
The biggest hurdle when incorporating a property business is usually the inherent CGT liability on any gains that crystallise when a property is transferred. As explained earlier, for tax purposes, the transfer of a property by an individual to a company will be a disposal for CGT purposes and will be deemed to have taken place at market value. The financial consequences can be severe inasmuch as
- The gain will be calculated on the deemed market value of the property less its original cost and the costs of any subsequent improvements/enhancements;
- The CGT rate on residential property is 18% or 28% depending upon whether the taxpayer is a basic or higher rate taxpayer. A significant gain could also push an otherwise basic rate tax payer into the higher rate band in that year;
- The taxpayer will be able to use their annual CGT allowance of £12,500 to offset some of the gain;
- The CGT will be payable to HMRC within 30 days of the transfer having taken place.
S.162 of the Taxation of Chargeable Gains Act (TCGA) 1992 offers the possibility to avoid CGT on the transfer of assets into a limited company through the application of Incorporation Relief. The relief applies where
“… a person who is not a company transfers to a company a business as a going concern, together with the whole assets of the business, or together with the whole of those assets other than cash, and the business is so transferred wholly or partly in exchange for shares issued by the company to the person transferring the business.” (TCGA 1992 s162(1)).
For the relief to apply however, strict criteria have to be met
- The Transfer – The transferor must be an individual or a partnership (general, limited or LLP) and the transfer must be to a company, in exchange for newly issued shares. If any part of the consideration paid by the transferee is not shares (for example by the creation of a loan account), CGT will be chargeable on the gain relating to that part of the consideration that is not shares.
- The Business – The transfer into the company must be that of a business and not just the assets. The word “business” is not defined by statute but HMRC accept that the meaning is wider than “trade” and, in some cases a property investment business can indeed qualify. A key case in this area was that of Elizabeth Moyne Ramsey v HMRC  UKUT 266 TC in which the Upper Tier Tax Tribunal ruled that residential property letting may indeed be considered a business for the purposes of Incorporation relief provided it possesses the characteristics of a business – e.g. that it is conducted seriously, regularly and for profit. However the tribunal went on to find that in the context of property investment and letting, whilst the same activities are equally capable of describing a passive investment, the key differentiator of whether or not letting is a business is ‘the degree of activity undertaken’. HMRC’s own interpretation of this is that the owner would be expected to spend at least 20 hours a week in activities indicative of a business before a claim for Incorporation Relief would be considered. By extension therefore, if someone is spending more than 20 hours a week actively managing their properties, its status as a business will be taken as a fact and the presumption that Incorporation Relief is available will apply.
- Going Concern – the business being transferred must be a going concern. For most property businesses, this shouldn’t present too much of a problem
- Entirety of the Business – the business must be transferred in its entirety although HMRC will accept any cash balances in the business not being transferred across to the ltd company.
Where Incorporation Relief is available, the relief doesn’t need to be claimed and will be applied automatically.
The gain arising is then rolled into the base cost of the shares (i.e. the base cost of the shares for tax purposes is reduced by the amount of the gain) and thus only gets taxed when the shares are eventually disposed of. The base cost of the properties transferred is adjusted to the market value at the date of incorporation. If the properties are then subsequently disposed of, any gain or loss arising will be calculated by reference to this cost and not the original cost (a significant CGT benefit).
Due to the inherent uncertainty in respect of whether the property business qualifies as a “business” for s162, it may be advisable to obtain advance non-statutory clearance from HMRC by writing to the HMRC Non-Statutory Clearance Team at Southend on Sea.
HMRC are particular in respect of the format of the application and taxpayers (or more likely, the taxpayers’ professional advisers) should refer to Annex A of HMRC’s Non-Statutory clearance technical guidance and follow the format therein.
Annual Tax on Enveloped Dwellings (ATED)
Companies that own residential property valued at more than £500,000 are required to make an annual return to HMRC and pay an annual tax on that property. Relief from ATED however is available if the property is let to a third party on a commercial basis and is not let to the shareholder(s) or anyone connected to them (although the return still has to be made)
Advantages of Incorporation
Some of the main advantages of incorporation for a property business are as follows …
- There is no restriction on the extent to which interest costs that can be relieved .
- Corporation tax is at 19% on income and gains which is lower than the rates of personal tax – especially for those who are on the higher rates of personal taxation.
- Income can be accumulated in the company and used for a variety of purposes such as reinvesting in other properties, repaying debt early or for distribution after retirement to avoid higher rates of tax.
- Any more of their own money an owner puts into a company (e.g. for property improvements) can be redeemed at a later date without any tax consequences (as it will be a withdrawal from a directors loan account)
- If ownership is to be passed or shared between family members, share capital offers greater flexibility than real property. This can be extremely helpful for Inheritance Tax planning.
- The first £2,000 of dividend income for each recipient is taxable at 0%.
- Investing via a limited company can also protect an individual’s personal credit score. If tenants fail to keep up with utility bills or council tax, the landlord can be held accountable and their credit score affected (because a lot of these issues are attached to addresses and their owners). When investing through a limited company, it is the company name that is connected, rather than the landlords.
Disadvantages of Incorporation
Despite its many advantages however, incorporating a property business comes with its problems as well, the most important of which are
- There will be an upfront cost in setting up the company and transferring the properties across, as well as any of the tax consequences discussed above.
- It is a requirement of incorporation relief that all of the properties that constitute the business must be transferred across to the limited company. This may present a problem where a landlord wishes to retain use of one or more of the properties (e.g.because he or his family live in it) and may result in adverse tax consequences.
- Any subsequent private use of the properties (once in the company) will give rise to a benefit in kind charge for the director/shareholder
- The requirement to file accounts at Companies House will result in both a higher compliance burden and the loss of a degree of privacy in the landlord’s business affairs
- There is no annual exemption on realised capital gains (whereas individuals benefit from a £12,500 per tax year exempt amount for capital gains purposes). This however maybe offset by the different rates of taxation
- A subsequent sale of a property and withdrawal of cash could result in a double charge. This is because the company will pay corporation tax on the gain made and then, once the proceeds are withdrawn as income by the owner, they too will be taxed as personal income.
- If the business comprises several rental properties and one is sold, the proceeds can only be extracted by way of income distribution.
- No relief will be available to the new company (following incorporation) for any losses or unused tax credit brought forward by the individual from earlier years
A particular complication to be mindful of is where the value of the net assets being transferred into the Ltd company is less than the gain being rolled over through Incorporation Relief into the base cost of the shares. The example below illustrates how such a situation might arise (figures in £’k) :-
In this situation, the owners in Scenario 1 have properties on which they have spent £4.2m and which are now worth £5.7m. After adjusting for other assets and liabilities including a mortgage of £3.9m, the business has net assets of £2.5. On incorporating the business, the owners decide they wish to retain the £500k cash balance and therefore the net assets they are transferring into their new company are £2.0m. This then is the cost of the shares in the new company. To avoid paying CGT on the property gain of £1.5m, the owners claim incorporation relief and as a result, the tax on the gain is avoided and the base cost of the shares for tax purposes is adjusted down from £2.0m to £0.5m. Should these shares be disposed of in the future, CGT on the disposal will be calculated as consideration for the shares less the base cost
In scenario 2, the same situation exists but with one key difference – the total mortgage borrowings are £4.9m instead of £3.9m – hence the net assets being transferred to the limited company are £1m after adjusting for the cash retained. Application of Incorporation Relief would now result in a negative base cost of £500k because the cost of the shares is less than the gain being rolled over. As it is not possible to have a negative base cost for the shares, the cost is reduced to nil and the excess (in this case £500k) is charged to CGT immediately. One way to avoid this would be for the owners to not withdraw the cash balances from the business on incorporation as planned as this would make the base cost of the shares equal to the gain rolled over.
Operating a property business through a limited company set up can be attractive in some circumstances, especially where the main objective is to grow the portfolio by reinvesting proceeds and the taxpayer isn’t looking to use gains on the properties as a short term income source. Ideally, the business should be set up as a limited company from the outset as the discussion above has shown, incorporating an existing property business can be complicated and many more considerations come into play. Furthermore, once incorporated it is virtually irreversible, or certainly very costly to unwind the structure, so it is a decision not to be made lightly.
For this reason, it makes sense to seek professional advice and to model the numbers upfront to ensure the implications and associated costs are fully understood prior to making a final decision.