Andrew Levene (BKL) answers a query on the tax implications of incorporating a buy-to-let business.
Question
My client, ‘John Smith’, is a successful buy to let investor who has built up a significant portfolio of investment properties. He now wants to run the portfolio as a proper business and thinks it would be helpful if the portfolio could be transferred to a company. Some of the properties are owned jointly with his wife, while others are owned with business partners under formal partnership agreements. What are the tax implications?
Answer
Although tax is not John’s driver, the corporation tax rate at 20% is lower than income tax rates of up to 45%, so undoubtedly there may be potential tax savings to be gained by incorporating. There can also be tax downsides.
If the owner of the company needs to distribute the company’s income, the effective rate of tax is similar to that which would have been incurred had the shareholder simply received rent directly.
For capital gains, although the corporation tax rate at 20% is lower than the CGT rate at 28%, on distribution the effective rate can be higher than 28%, so the individual could be better off holding the property directly.
If John is holding the properties for long-term rental income and capital growth, and does not need to distribute profits, a company could be tax efficient. The tax costs of incorporating need to be considered.
CGT
TCGA 1992 s 162 provides relief for the incorporation of a business, whereby the gain on transfer can be rolled over into the base cost of shares issued on transfer. Historically, HMRC’s view was that s 162 could not apply to property investments. This view was successfully challenged at the Upper Tribunal in Ramsay v HMRC [2013] UKUT 226 (TCC), [2013] STC 1764.
Mrs Ramsay owned a block of 15 flats. She had inherited a one-third share, but later acquired the other two thirds from her brothers with a bank loan. The property was later transferred to a company. She applied for planning permission to refurbish and redevelop the property, although no work had been done at the time of the transfer. The Ramsays dealt with the management and maintenance of the property themselves, spending around 20 hours per week on it, and had no other occupation during the period.
The UT decided that the correct approach was to ‘consider whether Mrs Ramsay’s activities were a ‘serious undertaking earnestly pursued’ or a ‘serious occupation’; whether they were an occupation or function pursued with reasonable or recognisable continuity; whether they had substance in terms of turnover; whether they were conducted in a regular manner and on sound recognised business principles; and whether they were of a kind that are commonly made by those who seek to profit by them. It concluded they were.
The FTT had previously decided in favour of HMRC. The UT said the FTT’s approach was incorrect, because the FTT had focused on the meaning of trade rather than business.
Previously, HMRC’s Capital Gains Manual (at CG65715) stated: ‘We do not accept that passive holding of investments or the holding of properties as investments amounts to a business.’ These words have since been removed, and CG65715 now states: ‘The Ramsay case endorsed the approach in American Leaf Tobacco [1978] STC 561 … confirming that for there to be a business for incorporation relief there has to be “activity” and that just a modest degree of activity would not suffice. It also shows us that it is the quantity not the quality of the activity that is important.’
The UT decision and updated HMRC guidance leave some uncertainty. What degree of activity is required by the taxpayer? If the Ramsays had not applied for planning permission for redevelopment, would their activity still have constituted a business? If the Ramsays had used a managing agent, would it still have constituted a business? As with a trade, it should not matter whether the taxpayer uses an agent, but this isn’t certain from the case, or HMRC’s guidance. Where the gains on the portfolio are large, it can be advisable to seek an HMRC non-statutory clearance.
Assuming that s 162 applies, the gain on transfer is rolled over into the base cost of the shares issued, which is reduced by the amount of the gain. If the base cost is less than the gain, the excess will be taxable on the incorporation disposal.
Section 162 is silent on the company’s base cost in the properties, so the normal rules apply. The base cost will be the consideration given for the properties, i.e. the value of the shares issued, subject to the market value rule in ss 17 and 18.
A downside to incorporation might be extracting funds from the company. On existing gains, because of the uplift in property base cost, the position on the sale of a property and distribution of proceeds may be similar to that which would have arisen had the property simply been sold directly. However, on gains arising post transfer, the disadvantage noted above can apply. Tax on distribution might be reduced by repaying share capital, although there is a risk that HMRC could argue that s 698 applies.
SDLT
Because John will be connected with the company, the market value rule in FA 2003 s 53 will apply.
Where the transferor is a partnership, this normal rule is overridden by the prescriptive rules in FA 2003 Sch 15. The impact of these provisions can be that to the extent the company is connected with the partners making the transfer, no SDLT may arise.
HMRC’s view is that mere joint ownership of property does not constitute a partnership (see HMRC’s Property Income Manual at PIM1030). Therefore, it shouldn’t be assumed that the properties held under partnership agreements can be transferred free of SDLT. For a partnership to exist, there must be a business carried on in common with a view to profit. This is a general law issue, but it might follow similar principles to whether a business exists for Ramsay or capital gains purposes.
Other points
Where capital allowances have been claimed, it should normally be possible to make an election under CAA 2001 s 198 on the transfer.
VAT should be neutral either because the transfer qualifies as a transfer of a going concern; or in some cases because VAT may have to be charged, although it should normally be recoverable by the company opting to tax and registering for VAT.
Andrew Levene (BKL) answers a query on the tax implications of incorporating a buy-to-let business.
Question
My client, ‘John Smith’, is a successful buy to let investor who has built up a significant portfolio of investment properties. He now wants to run the portfolio as a proper business and thinks it would be helpful if the portfolio could be transferred to a company. Some of the properties are owned jointly with his wife, while others are owned with business partners under formal partnership agreements. What are the tax implications?
Answer
Although tax is not John’s driver, the corporation tax rate at 20% is lower than income tax rates of up to 45%, so undoubtedly there may be potential tax savings to be gained by incorporating. There can also be tax downsides.
If the owner of the company needs to distribute the company’s income, the effective rate of tax is similar to that which would have been incurred had the shareholder simply received rent directly.
For capital gains, although the corporation tax rate at 20% is lower than the CGT rate at 28%, on distribution the effective rate can be higher than 28%, so the individual could be better off holding the property directly.
If John is holding the properties for long-term rental income and capital growth, and does not need to distribute profits, a company could be tax efficient. The tax costs of incorporating need to be considered.
CGT
TCGA 1992 s 162 provides relief for the incorporation of a business, whereby the gain on transfer can be rolled over into the base cost of shares issued on transfer. Historically, HMRC’s view was that s 162 could not apply to property investments. This view was successfully challenged at the Upper Tribunal in Ramsay v HMRC [2013] UKUT 226 (TCC), [2013] STC 1764.
Mrs Ramsay owned a block of 15 flats. She had inherited a one-third share, but later acquired the other two thirds from her brothers with a bank loan. The property was later transferred to a company. She applied for planning permission to refurbish and redevelop the property, although no work had been done at the time of the transfer. The Ramsays dealt with the management and maintenance of the property themselves, spending around 20 hours per week on it, and had no other occupation during the period.
The UT decided that the correct approach was to ‘consider whether Mrs Ramsay’s activities were a ‘serious undertaking earnestly pursued’ or a ‘serious occupation’; whether they were an occupation or function pursued with reasonable or recognisable continuity; whether they had substance in terms of turnover; whether they were conducted in a regular manner and on sound recognised business principles; and whether they were of a kind that are commonly made by those who seek to profit by them. It concluded they were.
The FTT had previously decided in favour of HMRC. The UT said the FTT’s approach was incorrect, because the FTT had focused on the meaning of trade rather than business.
Previously, HMRC’s Capital Gains Manual (at CG65715) stated: ‘We do not accept that passive holding of investments or the holding of properties as investments amounts to a business.’ These words have since been removed, and CG65715 now states: ‘The Ramsay case endorsed the approach in American Leaf Tobacco [1978] STC 561 … confirming that for there to be a business for incorporation relief there has to be “activity” and that just a modest degree of activity would not suffice. It also shows us that it is the quantity not the quality of the activity that is important.’
The UT decision and updated HMRC guidance leave some uncertainty. What degree of activity is required by the taxpayer? If the Ramsays had not applied for planning permission for redevelopment, would their activity still have constituted a business? If the Ramsays had used a managing agent, would it still have constituted a business? As with a trade, it should not matter whether the taxpayer uses an agent, but this isn’t certain from the case, or HMRC’s guidance. Where the gains on the portfolio are large, it can be advisable to seek an HMRC non-statutory clearance.
Assuming that s 162 applies, the gain on transfer is rolled over into the base cost of the shares issued, which is reduced by the amount of the gain. If the base cost is less than the gain, the excess will be taxable on the incorporation disposal.
Section 162 is silent on the company’s base cost in the properties, so the normal rules apply. The base cost will be the consideration given for the properties, i.e. the value of the shares issued, subject to the market value rule in ss 17 and 18.
A downside to incorporation might be extracting funds from the company. On existing gains, because of the uplift in property base cost, the position on the sale of a property and distribution of proceeds may be similar to that which would have arisen had the property simply been sold directly. However, on gains arising post transfer, the disadvantage noted above can apply. Tax on distribution might be reduced by repaying share capital, although there is a risk that HMRC could argue that s 698 applies.
SDLT
Because John will be connected with the company, the market value rule in FA 2003 s 53 will apply.
Where the transferor is a partnership, this normal rule is overridden by the prescriptive rules in FA 2003 Sch 15. The impact of these provisions can be that to the extent the company is connected with the partners making the transfer, no SDLT may arise.
HMRC’s view is that mere joint ownership of property does not constitute a partnership (see HMRC’s Property Income Manual at PIM1030). Therefore, it shouldn’t be assumed that the properties held under partnership agreements can be transferred free of SDLT. For a partnership to exist, there must be a business carried on in common with a view to profit. This is a general law issue, but it might follow similar principles to whether a business exists for Ramsay or capital gains purposes.
Other points
Where capital allowances have been claimed, it should normally be possible to make an election under CAA 2001 s 198 on the transfer.
VAT should be neutral either because the transfer qualifies as a transfer of a going concern; or in some cases because VAT may have to be charged, although it should normally be recoverable by the company opting to tax and registering for VAT.
driver, the corporation tax rate at 20% is lower than income tax rates of up to 45%, so undoubtedly there may be potential tax savings to be gained by incorporating. There can also be tax downsides.
