Incorporation of property ‘business’, Capital Gains Tax (CGT) and funding implications
The shock tax changes introduced by George Osbourne in the 2015 budget seriously affected many buy to let landlords.
It has led to widespread transfer of property portfolios to limited companies.
However, what some have failed to realise is that transferring a property portfolio into a limited company can create a significant CGT charge.
What were the tax changes?
Known as ‘clause 24’ the new rule effectively removed landlords’ ability to deduct the cost of their mortgage interest from their rental income when they calculate a profit on which to pay tax.
We’re now into year two of the four-year plan to reduce the amount of interest residential landlords can claim with this phased approach leading to higher taxes for landlords each year.
In the current tax year only 50% of interest will be allowed with that percentage reducing to 25% next year and 0% for tax year 2020/21 onwards.
In effect landlords will be taxed on turnover rather than profit, meaning that for some tax will be payable on non-existent income.
Why the rush to incorporate?
Buy to let landlords soon realised that this was only a problem which affected individuals who were holding properties as investments. Where the properties are held in limited companies there is no restriction of interest relief hence the widespread rush to transfer property portfolios to limited companies.
In transferring a property portfolio into a limited company a CGT charge potentially arises.
The basic rule is that a transfer of properties to a connected company is treated as if it were a sale of the properties at their current open market value which means that there is potentially a CGT charge where you are treated as having made a gain even though there is no actual cash available to pay the tax.
What about incorporation relief?
When CGT was first introduced, the issue of tax arising on incorporating a business in a limited company was considered and ‘incorporation relief’ was also introduced.
This relief was intended to assist people who wanted to incorporate their sole trader or partnership business into a company to secure limited liability.
However the relief also applies wherever a ‘business’ together with all the assets of the business or all the assets other than cash are transferred to a company as a going concern and the company issues shares to the transferor in return. It is a very specific relief and only applies in business for share transactions.
So, if landlords are thinking of incorporating their property businesses, it is important for them to know whether they will be considered a ‘business’ and therefore qualify for incorporation relief.
Can HMRC tell me if I qualify as a ‘business’?
In the past, HMRC have been willing to provide non-statutory clearances as to whether a business is actually a business for the purpose of incorporation relief and getting a positive answer could create a very favourable tax situation.
This was very useful when making the decision whether incorporation was the best option. However, because of the huge number of applications which were being made HMRC were struggling to have the manpower to give clearances and in August 2018 HMRC said that they will no longer give non-statutory clearances on the matter of whether a business is being carried on.
Unhelpfully they said ‘HMRC consider whether a business is being carried on is a question of fact and HMRC will not give clearance on this question.’
So how do I decide if I qualify as a ‘business’ for incorporation relief?
Unfortunately, those who drafted the statutory rules providing for incorporation relief didn’t include a definition of what a business was and so it is left to interpretation.
There are a whole array of property related activities, with at one end of the spectrum being an individual receiving rental income from a one bedroom flat, run by a management company and at the other end a portfolio of several hundred properties managed through a central office employing dozens of staff.
The individual would clearly not be regarded as running a business by HMRC for the purpose of incorporation relief whereas the latter situation most likely would be.
However, there are very many property related activity businesses which are at neither end of the spectrum and whilst it is important to determine what view HMRC will take, it is not easy to draw the line.
The importance of getting it right
If you incorporate your property portfolio into a limited company believing it qualifies as a business and discover you have got it wrong you could find yourself with a huge CGT bill. It’s too late to undo the transaction at this stage.
That’s why it is imperative that you seek professional advice before you make any decisions about incorporation. It’s even more important now given that HMRC no longer accept clearance applications from taxpayers requesting confirmation that a ‘business’ exists for CGT purposes prior to any incorporation.
We can assist with assessing the probability of HMRC accepting that a ‘business’ exists and if necessary building up a contemporaneous body of evidence referenced to relevant tax case law to give the best possible chance of the incorporation relief applying.
As these changes to interest relief kick in this will have implications for how some funders assess repayment cover and sometimes a more relaxed lending regime is applied to incorporated companies as opposed to personal borrowers.
Further, if you as a landlord are looking at the benefits of incorporation and your current portfolio is subject to borrowings this will involve agreeing a restructuring or renegotiation of facilities with your current lender/(s) or potentially exploring alternative funding options. A key focus of any lender will also be the professional advice you have taken, as an unplanned CGT hit would have material implications for your ongoing cashflow and therefore the ability to service your debt.
The information was correct at time of publishing but may now be out of date.