HMRC have recently issued a ‘spotlight’ commenting on certain property business incorporations, which they believe to be tax avoidance.
The transactions in question seek to enable full tax relief for mortgage interest and purport to achieve a tax efficient transfer of properties to a limited company without Inheritance Tax and Capital Gains Tax arising.
The arrangements in question are quite specific, and it remains to be seen whether HMRC will be successful in litigating such cases. The details of which we will not go into in this article.
The release of spotlight 63 has, however, brought the tax implications of property incorporations into sharp focus.
So, what are the benefits of incorporating a property rental business and what barriers do landlords face in transferring properties to a limited company?
Mortgage interest restriction
Many landlords have been able to build up highly geared property portfolios due to historically low interest rates, and the added benefit, prior to 2017, of the ability to fully deduct mortgage interest against taxable profits.
However, higher and additional rate taxpayers no longer receive full tax relief for mortgage interest.
Limited companies, on the other hand, do not face the same restriction and can therefore continue to benefit from a full tax deduction for mortgage interest.
Tax on profits
The main rate of corporation tax is 25%, this is favourable when compared to the higher and additional rates of income tax.
Therefore, those landlords with other personal income, or those who own a number of properties, are faced with much higher tax liabilities on their rental profits, than if the properties were owned by a limited company.
Of course, the benefits of incorporation are eroded where there is a need to draw all of the available rental profits on an annual basis, as Corporation Tax is paid in addition to income tax suffered on distributions of net rents in the form of dividends. Therefore, the tax benefits of incorporation are primarily for those who are happy to ‘roll up’ their rental profits over a period of years.
Owning property via a limited company provides greater flexibility for passing assets down to younger generations than owning the properties directly. It is easier to gift shares than assign a share of a property to children thus creating greater opportunities for Inheritance Tax planning. It is also possible to alter rights of shares before they are gifted into ‘freezer’ and ‘growth’ shares in order to mitigate the Capital Gains Tax and Inheritance Tax which might be due on an outright gift.
Barriers to incorporation
Whilst the benefits of incorporation can be attractive, the costs of incorporating a property rental business often outweigh the benefits.
Capital Gains Tax will ordinarily be due on a transfer of properties to a connected company as if they had been sold to a third party. For more substantial property portfolios it might be possible to defer the Capital Gain via ‘Incorporation Relief’, however, case law suggests that the portfolio needs to require a certain level of ‘activity’ in managing for it to qualify as a property rental business capable of incorporating. This threshold is particularly high, as a rule of thumb HMRC suggest the activity needs to be 20 hours a week but it may be possible to qualify with slightly less time committed depending on the circumstances.
Stamp Duty Land Tax will also apply on the value of the properties transferred, this will apply at the normal rates and with the additional 3% which automatically applies on acquisitions by companies. There is a relief from Stamp Duty Land Tax where the transfer is made by a partnership to a company owned by the same owners. This is a very specific relief which HMRC are looking at very closely so I would suggest speaking to a member of our Tax Team if you believe this applies.
Lastly, mortgage lenders are likely to consider a transfer to a Limited Company as a new lend and therefore exit charges and potentially higher rates on borrowing are likely to apply. This is particularly problematic when looking to claim Incorporation Relief to defer Capital Gains Tax because there is a condition to the relief that the company gives no other consideration other than the issue of shares, the assumption of debt isn’t necessarily classed as ‘other consideration’ by way of a HMRC concession, however, many lenders do not allow existing debts to be novated therefore creating a potential issue for the relief.
In many cases, it is decided that these barriers cannot be overcome and therefore clients often either continue with their rental portfolio as is, or alternatively look to acquire only new properties via a limited company.
Due to the above reasons, a number of providers have created schemes which aim to circumvent these barriers. These have been widely promoted and the planning involved has been undertaken by many landlords. We would urge caution to anyone looking to incorporate their property rental business to speak to one of our Tax Team to understand how these issues apply to their specific circumstances.
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