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Property Tax Insider’s March 2013 article ‘Problems of Owning a property through a Company’ detailed the financial ‘pros’ and ‘cons’ of property ownership via a limited company; the main benefit being that companies are charged to corporation tax on net rental profits made at rates less than income tax rates. Although companies do not have a personal allowance, if the profits from a property business would be taxed at higher rates as an individual, then it would potentially be more beneficial for the properties to be held inside a company, given that the rental profit would then be taxed at the lower rates of corporation tax.
However, incorporation can, in itself, bring problems - not least that the incorporation of a property business currently operating will involve the disposal by the sole trader or partnership owner to the company of the property assets for capital gains tax (CGT) purposes. The ownership of the land or buildings will be transferred into the name of the company (something that might not be possible should the property purchase be subject to a mortgage), the disposal normally being treated as taking place at market value on the basis that the parties are ‘connected persons’. This could result in a large tax bill. In many cases, there could be stamp duty land tax costs as well.
‘Market value’ is the amount that the property might reasonably expect to fetch if placed on the open market. The valuation is made with no allowance for any reduction in the market value which may result should the whole asset be placed on the market at the same time rather than in individual separate parts (or parcels) of land (TCGA 1992, s 272).
A company is connected with another person if that person has control of that company or if that person and persons connected with him have control (TCGA 1992, s 286).
Deferment of charge - incorporation relief
However, there is the statutory relief of ‘incorporation relief’ available which allows the CGT charge on the whole or part of the gains to be postponed, where certain conditions are satisfied. The effect of incorporation relief is that there is an effective ‘rollover’ of gains on disposal of the assets, against the cost of the shares until the person transferring the business disposes of the company shares.
Incorporation relief – Is there a ‘business’?
One of the difficulties in succeeding in a claim for ‘incorporation relief’ with reference to a property rental business in particular, is in determining that there is actually a business in place because the relief is not available on investment properties. This difficulty may have been reduced following the recent Upper Tribunal case of Ramsay v Revenue and Customs. In this case, the taxpayer was the landlord of a large property which had been converted into ten flats, five of which were occupied by tenants. The property was transferred to a company, in exchange for shares in that company under an‘incorporation relief’ claim.
HMRC disallowed the claim arguing that letting is an investment activity and as such there was no ‘business’. The taxpayer appealed. The First Tier tribunal approached the question by looking in detail at the taxpayer’s activities in connection with the letting and administration of the property to consider whether those activities were sufficient to be termed a ‘business’. The Tribunal found that the scale of the activities undertaken by Mrs Ramsay and her husband to be ‘normal and incidental’ to the owning of an investment property and as such disallowed the claim. Interestingly it was noted that the property profit had been declared under what was then ‘Schedule A’ (i.e. income from property) on the personal tax return and that at no time had it been suggested that a business (under ‘Schedule D’) was being carried on. The case went to appeal and was overturned last month by the Upper Tribunal, confirming that a business was in place and therefore allowing the claim for incorporation relief to stand.
From the details of this case it seems that to succeed with such a claim the activities will need to be performed over and above those which are incidental to the owning an investment property. The amount of time spent is likely to be relevant in terms of establishing that a proper business is being carried on, not least as a going concern as distinct from just being an investment company that passively takes the rental deposits.
Must ‘incorporation relief’ be claimed?
Incorporation relief is automatic if certain conditions apply, namely that there is a business and that the business, together with all of its assets (except cash) is transferred as a ‘going concern’ in exchange wholly or partly for shares in the company. The claim for ‘incorporation relief’ is voluntary, however - just because property is placed within a company does not necessarily mean that a claim must be made. A claim may not be possible in any event unless all the business assets are sold, for example. The claim may also not be practical, as the exchange for shares means that the value can only be withdrawn by the sale of those shares; being a private limited company, the market for those shares will be restricted. Further, if a residential property held by the company is valued in excess of £2 million, then unless the property is let out to a third party on a commercial basis, it will be subject to the new annual tax on enveloped dwellings from April 2013.
What else can be done?
A higher rate taxpayer who is the owner of more than one property can still benefit from the use of the lower rates of corporation tax in a situation where a company is created but the properties remain in the name of the taxpayer. A set amount (say, 15% management charge) is paid from the rental income received by the taxpayer to the company for the service role of managing the property business. The management/service charge is thus an allowable expense against the rental income received. The management service charge income remains in the company, and possibly drawn down as dividends later, perhaps when the shareholder is no longer a higher rate taxpayer. It is suggested that the number of properties concerned in this scenario should be at least (say) four or five as the cost of preparation of company accounts is higher than for a sole trader/property investor and the higher the number of properties the higher the management charge and higher the tax relief thereon. There will be legal fees initially as a proper agreement between the company and the owner will be required but these fees will be tax deductible against the management income received.
Practical Tip :
It is possible to apply to HMRC for advance clearance as to whether ‘incorporation relief’will be available on a transfer of rental properties to a company. Whilst an application will confirm the situation, the downside is that there is no right of appeal against such rulings so the result could be a ruling that ‘incorporation relief’ is not due and nothing can be done to reverse this ruling.
This is a sample article from the monthly Property Tax Insider magazine. Go here to get your first free issue of Property Tax Insider.