This page is not intended to be treated as professional tax advice, which the author is not qualified to give. It is intended purely to provide information to enable further research. Any reliance placed upon it is entirely at the readers’ own risk. Tax law is complex and it is highly recommended that specialist advice from appropriately qualified individuals is sought before making decisions in relation to liabilities, exemptions and reliefs.
Benefits of Incorporation
At the time of writing, rental income from residential property received by individuals is subject to income tax and is treated as additional to (not separate from) the individual’s salary – so that it is taxed at 20%, 40% or 45% depending on the individual’s other income. The tax is applied to gross income, i.e. the actual sum received rather than the net profit.
Rental income received by limited companies on the other hand is subject to Incorporation Tax. The “small profits rate”, applicable to companies which generate profits of £50,000 per annum or less, is 19%. Companies can deduct expenses from the gross rental income, including mortgage interest payments (though not capital repayments) and business expenditure such as repair costs, so that they are only taxed on profit.
Limited companies are therefore at a significant advantage compared to individuals in respect of tax on rent.
Section 53 of the Finance Act 2003 – the “deemed market value rule”
In light of the tax advantages, lots of individual landlords elect to create limited companies and transfer their properties to those companies – but doing so can lead to a substantial, and often unexpected, SDLT (Stamp Duty Land Tax) liability, even though the company may not pay any money to the individuals for the properties. That is because of s53 Finance Act 2003, which says that where a company acquires property from its directors or shareholders, the purchase price for SDLT purposes is deemed to be the greater of a) the actual price paid; or b) the market value of the property. Furthermore, all acquisitions of residential property by companies are subject to the 5% additional property surcharge. So, a company that acquires a property valued at £200,000 from its directors will pay SDLT of £11,500 – unless it is entitled to some relief or exemption.
Partnerships
If two or more people own property jointly and they are operating a “property partnership business” then they may be able to rely on the special partnership provisions contained in Schedule 15 of the Finance Act 2002.
What is a Property Partnership Business?
Not everyone who owns property which they let to tenants can be said to be operating business. They need to actively manage their portfolio so that it becomes a job, though it does not have to be their only or even their main job. There is no statutory provision that dictates how much time a person must spend running the business, but case law suggests it should be at least 20 hours per week. Most activity, such as collecting rents, carrying out/arranging repairs, finding and vetting new tenants, looking for new properties, accounting work etc will count.
Naturally, in order to genuinely be spending 20 hours per week working on the business the partnership will need to own more than one property, probably 3 or 4 at a minimum though individual circumstances will vary.
Although there is no minimum time period for which the partnership must operate before incorporating, in order not to fall foul of the General Anti Avoidance Rule (see later), it is generally recommended that it be in existence for at least 3 years.
What if the Property is Not in the Names of all the Partners?
It would generally be the case that all of the members of the partnership would be recorded at Land Registry as legal owners and that is useful, but not essential as it is the beneficial ownership that counts. Sometimes all the properties will be in the name of one or other of the partners, or else some will be in one name and some in another. There should as a minimum be a declaration of trust in which the registered proprietor declares that he/she holds the property on trust for all of the partners. It should be noted however that a declaration of trust which vests a beneficial interest in someone else is a “land transaction” and a potential trigger for SDLT liability.
Business Transfer Agreements
In order to avoid Capital Gains Tax on incorporation, the whole of the business must generally be transferred at the same time. This is sometimes achieved by way of a “business transfer agreement”, under which the partners agree to transfer the business to the limited company in return for shares issued to the partners.
Paragraphs 18 and 20 Schedule 15 Finance Act 2003
Once established that the partners are operating a property partnership business, it is necessary to establish that one of paragraphs 18(1) (a) or (b) of Schedule 15 of the Finance Act 2003 apply and if so to calculate the “sum of the lower proportions (SLP)” by reference to paragraph 20. The market value of the property for the purposes of calculating SDLT is MV = (100 – SLP)%. To calculate SLP:
Step 1 – Work out who the relevant owners are
A relevant owner is someone who:
- owns part of the property immediately after the transaction; and
- immediately before the transaction was either:
- a partner in the partnership; or
- connected to one of the partners.
Make a list of everyone who meets these conditions.
Step 2 – Match each relevant owner to their corresponding partner(s)
For each relevant owner, identify the partner (or partners) they are linked to. A partner is a corresponding partner if, immediately before the transaction, they:
- were a partner; and
- were either:
- the relevant owner themselves; or
- connected to the relevant owner.
If no relevant owner has a corresponding partner, the calculation ends here. The sum of the lower proportions is 0%.
Step 3 – Divide up each relevant owner’s share
For each relevant owner:
- Work out what percentage of the property they own after the transaction.
- Split that percentage between one or more of their corresponding partners.
When you’ve finished, every relevant owner’s share should have been allocated.
Step 4 – Work out each partner’s lower proportion
For each corresponding partner:
- Add together all of the percentages allocated to them in Step 3.
- Work out their partnership share (using Paragraph 21).
- Compare the two figures.
- Keep whichever is lower.
This is that partner’s lower proportion.
Step 5 – Add the figures together
Add together the lower proportion for every corresponding partner. The total is the sum of the lower proportions.
The Mechanics of Incorporation
Incorporation can involve one or two stages. Either the beneficial interest and legal title will be transferred simultaneously, or else the beneficial interest will be transferred first, with the legal interest following later. The latter will typically happen where the owners want to take immediate advantage of the tax benefits of incorporation but cannot immediately transfer the property, perhaps because it is mortgaged.
Trigger Date for SDLT
Ordinarily when a property is transferred, the legal and beneficial interest transfer at the same time, but the value is in the equitable title, so that if the property is placed on trust for the company, the date of that trust deed is the trigger date for SDLT, and a return should be submitted at that point – unless there is no need for a return because paragraphs 18 – 20 of Schedule 15 FA 2003 are being relied upon. SDLT cannot be deferred until the transfer of the legal estate and if that is attempted, penalties and interest will be incurred.
Consideration in Transfer
The consideration in the transfer of the legal title should reflect what the company actually paid, in money or money’s worth, for the property. Sometimes the company will pay the entire purchase price in cash but more usually it will pay cash (the net mortgage advance that the company will receive and, at least notionally, pay to its shareholders, the property owners) plus security in the company for the benefit of the owners in the form of a director’s loan.
Regardless of when the legal title transfer takes place, the “price” is whatever the company paid for the property when the equity was assigned to it. This can cause an issue when attempting to mortgage the property at the time of the transfer, as lenders will often insist that the price recorded in the transfer is the value at the time of the mortgage. This can be an intractable problem.
Directors Loans
Where a property is transferred by the shareholders to the company, the difference between the market value and the actual cash paid over on completion is usually recorded in the company accounts as a director’s loan. The advantage of doing that is that, when the shareholders then take the rental income out of the company for themselves they can treat it as repayments of the loan (until the debt is exhausted). Director’s loan repayments are tax free, since tax was already paid on the invested cash when it was earned.
General Anti Avoidance Rule (“GAAR”)
Section 75 of the Finance Act 2003 contains a “general anti-avoidance rule”, which is a catch all provision and in simple terms, it says that any transaction or series of transactions, the sole purpose of which is to reduce or eliminate SDLT liability, should be treated as though they had not taken place and instead tax should be assessed on the basis that the transaction is directly between the original owner and the ultimate owner. There are caveats that sometimes apply, but it always needs to be considered when assessing the legitimacy of any tax mitigation scheme.