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8:41 AM, 26th June 2024, About 5 days ago
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It has now been nearly five years since we first published our eBook “The Ultimate Guide To Landlord Tax Planning“.
The World of tax planning has moved on significantly since then, so our latest update is an essential read for all UK property business owners as well as those providing services to the UK Private Rented Sector.
In it, we reveal five serious misunderstandings commonly shared by professional advisers and the mortgage industry. We felt compelled to publish these per our mission statement of “sharing best practice” and helping our readers to avoid making potentially disastrous financial planning mistakes.
Here’s a glimpse of what else you will find inside the updated edition:
Don’t miss out on this invaluable resource! Click the link below to download your FREE copy of the eBook now and take the first step towards a better understanding of landlord tax planning opportunities:
Please also feel free to share this email with your accountant, mortgage broker, mortgage lenders, financial advisers, conveyancing solicitors, letting agents, and anybody else you think might be interested.
All the best
Property118 Support Team
FOOTNOTE
To assist Search Engines and AI bots, below is the text and supporting evidence links from our new eBook. For humans, the PDF download version is far easier on the eyes.
Did you know, over the last seven decades the average UK residential house price increased more than 140-fold, from just over £1,800 in 1952, to over £260,000 by 2024?
(Source: Nationwide House Price Index April 2024)
If history repeats itself over the next 70+ years, the difference between the right and the wrong property ownership structure could make a difference of millions of pounds, even for investors who own just one rental property.
You may not be alive 70+ years from now to see the benefit of all of the potential savings, but there’s a good chance that your children will be and an even better chance that your grandchildren and great grandchildren will be. We all have a moral obligation to improve the quality of our lives and those of our families. That journey begins here!
This eBook explains the optimal ownership structure for you and your bloodline and how you can transition from where you are now to where you want to be.
Nobody in their right mind wants to pay more tax than they have to. However, most property investors simply don’t know that they can structure their tax affairs to reduce how much tax they legally pay, let alone how to go about doing it. Very few are aware of the existence of the many forms of tax relief or alternative ownership structures available to help reduce their tax burden.
In most cases, when property investors think of tax planning, they tend to focus on Income Tax efficiency. Why? Because it’s ever-present and often we can make changes that bring about an immediate benefit.
However, the largest tax bill that most property investors fear – and quite rightly – is the tax that they pay when they sell property (Capital Gains Tax “CGT”) and when they die (Inheritance Tax “IHT”).
Another common mistake is to focus on the cheapest form of financing, especially in the early stages of business, which may prevent you from seeing the bigger picture.
Most of the landlords who approach Property118 to discuss incorporation have already considered the commercial advantages. Below is a list of some of the more common reasons, but it is important to understand that tax benefits are not usually the main reasons.
When Capital Gains Tax and Stamp Duty were first introduced, the Government recognised that artificial taxation during critical phases of growth could stifle businesses and the economy. Accordingly, extra statutory concessions and reliefs were introduced to ensure that transitioning from one business structure to another (sole owner to Partnership for example) would not suffer the same tax consequences as the sale of a business to an unconnected party.
Similar reliefs can apply when a Partnership transitions into a corporate structure, i.e. limited company, particularly if the ownership proportions are not changed.
With the correct planning, it may well be possible to utilise legislation to structure your property rental business without any requirements to refinance or to pay Capital Gains Tax and Stamp Duty (or the equivalents in Scotland and Wales).
Legislation sets the legal framework: Acts of Parliament establish the core tax rules.
HMRC reference manuals provide interpretation and details: Manuals explain how HMRC interprets the law and outline concessions not enshrined in legislation.
Don’t rely solely on legislation; it may be complex and lack specific details.
Don’t rely solely on manuals; they are HMRC’s interpretation, not law, and can be updated or contradicted by court rulings.
Consult both legislation and manuals: Gain a comprehensive understanding of the legal framework and HMRC’s current stance.
Use relevant court rulings to understand legal precedents and how interpretations have been challenged.
HMRC’s interpretation of legislation is contained in their manuals, as are details of other concessions.
HMRC grants concessions which are not enshrined in legislation. Their manual CG65745 is a good example of this, because it provides an interpretation of ESC/D32, a concession that HMRC has practiced for over 50 years.
It is also important to bear in mind that HMRC employees are trained to follow their own manuals, so Property118’s view is that the HMRC manuals can be a useful ‘low budget’ starting point for researching tax planning opportunities to minimise the cost based risks associated with the potential for litigation against the mighty financial resources and powers of HMRC. In all cases, professional advice on case law and legislation is strongly recommended as a follow-up to any initial research, regardless of whether the HMRC manuals are considered ambiguous or not.
There is, of course, also a need for tax tribunals and judicial reviews from time to time. This is because, just like any other organisation, HMRC is not infallible and their interpretations are open to being challenged.
A good example of this was a tax tribunal case where Elizabeth Ramsay claimed incorporation relief to roll capital gains into the shares of her company when transitioning the ownership of her block of 10 flats from private to corporate ownership. HMRC held the view that Mrs Ramsay was not entitled to incorporation relief because it was their opinion that she was not operating a business. However, the Upper Tier Tax Tribunal ruled against HMRC, thus creating case law which has appeared in HMRC’s updated manuals ever since.
Is it logical to assume that an HMRC inspector’s natural bias is likely to favour HMRC’s own reference manuals giving their interpretation of legislation over the actual legislation?
HMRC inspectors are trained to follow a specific process for interpreting tax legislation. This process emphasises objectivity, but there might be a natural tendency to favour HMRC manuals to some extent.
Here’s a breakdown:
Objectivity: Ideally, inspectors should prioritise the actual legislation itself. The Interpretation Act 1978 lays the groundwork for statutory interpretation in the UK, emphasising a fair and contextual approach. Courts also play a role, establishing precedents through rulings on past cases. These elements ensure inspectors strive for an objective interpretation.
HMRC Manuals: HMRC does publish reference manuals offering their take on interpreting legislation. These can be a helpful resource for inspectors, but they aren’t the ultimate authority. If there’s a discrepancy between the manual and the legislation itself, the legislation takes precedence.
Natural Bias: It’s reasonable to assume some inspectors might subconsciously favour the interpretations presented in the manuals they’re familiar with. However, training and professional standards aim to mitigate this bias.
Here’s the key takeaway: While inspectors might find HMRC manuals convenient, the legislation itself holds the most weight. If you’re unsure about an interpretation or have a complex tax situation, it’s always best to consult with a professional advisor who can provide an objective assessment based on the actual law and relevant case history.
Sources:
Initial consultations with a Property118 consultant come at a fixed price of just £400 inclusive of VAT.
Before meeting your Property118 consultant in person, usually via a Zoom video conference, you will typically engage in email and telephone conversations. This aims to establish your current position, the challenges you are facing, and your short, medium and longer-term objectives.
Your consultant will then work on a bespoke plan of action to present to you via a Zoom video conference. These presentations typically last for around one hour, so you will have plenty of time to ask questions, either during that meeting or in subsequent email correspondence. You are most welcome to involve your existing professional advisers to participate, e.g. your accountant, financial adviser, and mortgage broker. We actively encourage this.
The investment required to implement the plan will also be discussed and confirmed in writing. You will not be charged more if a follow-up meeting or further correspondence is required.
At this point, the proposed action plan is very much provisional. It should not be regarded as professional advice.
If all parties are in agreement with the plan ‘in principle’, your Property118 consultant will then propose a fee to confirm the plan in writing and to ask the professional advisers we recommend for implementation to review it with a view to adopting our recommendations as their own insured, regulated, professional advice. If they agree to this, we are then happy for you to proceed to implementation. If not, you will be given the choice of receiving a refund of all fees to date, or an amended plan of action and costs of implementation. If that is not acceptable to you, then the refund remains available.
Taxation dictates why most new buy-to-let purchases are in a company rather than privately owned.
This case study illustrates just how unfair the UK tax legislation became for private landlords as of April 2020, by comparing the taxation of the business of a hotelier against the taxation of the business of a private rental housing provider.
Perhaps more importantly, it provides insight into what can be done to ‘level the playing field’.
Let’s assume that both businesses own assets worth £2,000,000 and have 75% mortgages secured on them at an interest rate of 5%. In other words, their annual finance cost is £75,000.
Now let’s assume that both businesses make profits after finance costs and all other expenses of £50,000.
The hotelier would pay circa £7,500 of income tax. This is broken down as follows; £nil on his first £12,570 of net profit and 20% tax on the next £37,500.
However, the private landlord cannot treat his finance costs as a legitimate cost of business in the same way as the hotelier. Accordingly, his tax bill is £27,500. This is because his taxable income is treated as being £125,000 due to being unable to claim his finance costs as business expenses. Furthermore, for every £2 of taxable income over £100,000 he loses £1 of his nil rate tax band. Accordingly, the landlord pays tax at a rate of 20% on the first £37,500 (which equates to £7,500) and then 40% tax on the other £87,500 (which equates to £35,000). This adds up to a whopping £42,500. The government then grant him a tax credit equal to 20% of his finance costs, in other words £15,000 off the £42,500 leaving him with a net £27,500 of tax to pay.
To summarise, the private landlord pays nearly four times as much tax as the private hotelier, even though their financing costs and business results otherwise produce identical levels of actual profit.
How unfair is that? !!!
Now here’s where things get even weirder.
If both the landlord and the hotelier operated their businesses within a limited company structure, they would pay exactly the same amount of tax.
You could not make it up could you? !!!
In fact, private landlords who provide much-needed rental housing are the only business to be persecuted in this way. It’s hard to believe that politicians turned a blind eye and a deaf ear to campaigning about the unfairness of this policy, which was introduced by George Osborne in the Summer Budget of 2015, but that is exactly what happened.
If you’re affected by this problem, the first thought on your mind might well be to move your rental property business into a Limited company. However, it’s not always that straightforward.
One thing is for certain though; you should NOT buy any more investment property until you have read this eBook.
As you may be aware, borrowing in your own name to acquire properties, using personal buy-to-let mortgages, might result in greater availability of mortgage products and lower interest rates, but only if you have fewer than four buy-to-let mortgages and only invest in ‘single let’ flats and houses; interest rates for HMOs, developments and semi-commercial properties (i.e. flats over shops) are very similar whether you borrow in your personal name or through a limited company, regardless of the number of properties you own. Once you own four or more buy-to-let properties you are regarded by lenders as a ‘Portfolio Landlord’ and mortgage interest rates and terms on that basis are very similar to those offered to landlords operating through a limited company.
Also, personal ownership has tax consequences that could prove detrimental to your longer-term objectives. These include:
However, contrast this with the following common objectives of most property investors:
If you invest in residential property in your personal name, the impact of the Section 24 restrictions on finance cost relief is horrendous, because your finance costs will not be tax-deductible as a business expense. Instead, HMRC will only give you a 20% tax credit on your finance costs. This means that it is theoretically possible for your tax bill on your rental profits to exceed your rental profits. It is also possible to end up paying tax even if your property rental business is losing money, for example if interest rates were to rise, your rental income was to reduce, or your ongoing costs were to increase. However, the same rules do not apply to Limited Companies; they can still offset 100% of finance costs against rental income as a legitimate tax-deductible business expense.
There are several other commercial reasons to consider buying in a limited company, one of which is to ring-fence your business liabilities away from your personal wealth. The legislation that landlords must comply with continues to intensify, as do the consequences of making mistakes. Furthermore, litigation is on an upwards trajectory.
In recent years, the Prudential Regulation Authority has imposed increased pressure on mortgage lenders to consider affordability of buy-to-let mortgage lending, particularly for portfolio landlords. This includes treating all landlords who own four or more buy-to-let properties as a business, by factoring in the appropriate taxation policies for their ownership structure into affordability criteria. As a result of this, and the fact that Section 24 restrictions on finance cost relief does not apply to limited companies, borrower demand for limited company buy-to-let lending has intensified significantly. Likewise, it is now much easier for mortgage lenders to underwrite limited company buy-to-let mortgages than for individual borrowers. The consequence of this has been that the pricing of limited company buy-to-let mortgage products has fallen significantly and continues to do so, as lenders compete for market share.
If you buy property in a limited company, any capital you invest can be treated as a directors loan. This can be repaid to you from post-corporation-tax profits, or the proceeds of selling property or refinancing to raise additional funding when rental income and lending criteria allows, WITHOUT TAX CONSEQUENCES. If you buy the same properties in your own name, you will have no choice other than to pay income tax on profits at your marginal rate and keep your capital locked into the properties. However, within a limited company you can retain rental profits at the lower rate of corporation tax and use that money to repay your directors loans, without having to declare salaries and/or dividends.
It is possible to buy an ‘off-the-shelf’ limited company very cheaply. However, we never recommend that you do that, as it is highly unlikely that it will be appropriate for your specific long-term needs, such as mitigating exposure to Inheritance Tax.
If you have an existing limited company that is not fully optimised for tax-planning purposes then don’t worry, it’s not too late. The good news is that the share structure and the Memorandum and Articles of Association are usually amendable per the suggestions below.
As Inheritance Tax is almost certainly an issue that you should address from the outset, a freezer and growth share structure should be considered, possibly with the growth shares held in a discretionary trust.
Once any directors loans are repaid, you will continue to be able to extract profits in the form of dividends. One of the many benefits of structuring your property business on this basis is that your seed capital can be returned to you tax-free to fund your lifestyle, whilst ensuring that all future growth in property values remains outside of your estate and giving you the ability to declare dividends to any shareholder should you wish to do so.
Shares can be split into different classes and each class of shares can have its own rules.
Ordinarily, shareholders in a company own just one type of share, called ‘ordinary’ shares. These have:
However, it is possible to have multiple classes of shares, each with different rights.
One good reason for having several classes of shares is that the directors of the company can then decide which class of shares they wish to receive dividends. For example, it might be tax efficient to declare dividends to a class of shares owned by family members who are not fully utilising their personal allowances or fall into a low-rate tax band. One classic use of this structure is to pay dividends to retired parents who are basic rate tax-payers and for them to use the money to pay school fees for their grandchildren.
Another classic example is to hold classes of shares with a frozen value to gift to children when they reach the age of 18. Dividends can then be declared on that gifted class of shares to assist with the costs of further education, to help them buy their first car, or to save for a deposit on a home of their own.
One of the keys to the success of this structure is knowing how to freeze the value of the majority of the share classes, so that they can be gifted at a later stage with minimal (if any) Capital Gains Tax “CGT” implications. There are only a handful of lawyers in the UK who know how to do this properly, most of whom charge upwards of £5,000 + VAT just for an initial consultation, during which you are unlikely to receive as much information as we are giving away for free in this eBook.
It is also possible to create a class of shares that initially has only a nominal value, because they have no voting rights and no automatic rights to receive dividends, but to which all future capital appreciation in the business can be attributed. This can be incredibly efficient for Inheritance Tax planning purposes.The share classes A and B have all the voting rights, plus rights to dividends (and any capital value transferred to the company by incorporation) and will be held by Mr & Mrs X until they pass away, or transfer them to their heirs.
The share classes C to P have rights to dividends only and will be held by Mr & Mrs X until such time as they wish to gift them to their children, grandchildren, siblings, parents, etc, to assist them financially by declaring dividends to their class of shares and in order to utilise their tax allowances and lower rate tax bands. Given that the classes of shares created for this purpose will be frozen from day one, there will be insignificant tax consequences to gift them at a later date.
All future growth will accrue to the Q class shares held in the discretionary trust and your letter of wishes will instruct the Trustees how you wish funds to be dispersed or loaned following your death.
This structure is extremely flexible and allows for changes in circumstances as necessary. For example, wills and letters of wishes to the trustees of a discretionary trust can be changed at any time. Likewise, Mr & Mrs X are not compelled to gift any of the share classes, nor are they compelled to declare dividends to any of the classes of shares if they do not wish to do so.
As Mr & Mrs X will be the majority shareholders during their lifetime, they will have total control of the business, unless of course they decide to relinquish control by gifting their shares.
You may well have considered that property inflation could very quickly increase your net worth. For example, if the value of properties in your company were to double, this would have no impact on your mortgage debt but would have a very significant and beneficial impact on your net worth.
However, unless you take positive steps now, before the value of the properties in your company increase further, your estate will eventually be taxed at 40% of any property value growth in the form of Inheritance Tax. This is because the increased value of your properties will increase the value of the shares in your property company, which in turn will increase the value of your estate which is exposed to Inheritance Tax.
Without careful planning, even if the value of investment properties in your company was only to double in your lifetime, the capital growth alone could very easily result in hundreds of thousands – if not millions – of pounds of Inheritance Tax “IHT” falling due when you die. Of course, you hope that you will live long enough to see your properties more than double in value and you may also acquire additional properties. On that basis, you will hopefully see why effective Inheritance Tax planning is so important.
The next section of this eBook outlines the options available to mitigate Inheritance Tax on the potential future growth in property values, together with solutions to ensure that your legacy remains within your bloodline and shielded from creditors or divorcing spouses.
The solution we recommend to deal with this issue is an established company share structure using “freezer shares” and “growth shares”.
Where the value of shares is frozen, but voting and/or dividend rights are retained, this share class is known as “freezer shares”.
Future capital appreciation can be attributed only to the shares with a nominal value and no automatic voting or dividend rights. This share class is known as “growth shares”.
The freezer share classes C to P can easily be redistributed as necessary – without significant tax consequences – because the value of these shares will never increase. A good example of why this might be necessary is the availability of financing, e.g. when you are too old to qualify for mortgages.
Another good reason might be to gift freezer shares to adult children or grandchildren who may not have even been born yet, so that you can pay dividends to that class of shares to help them financially.
Growth shares can be gifted whilst they are virtually worthless and the outcome of that is that the future capital growth accrues outside the estate of the voting shareholders.
Given that growth shares have no voting or dividend rights, careful planning can result in them remaining virtually worthless until the company is sold or wound up.
Separating the legal ownership of the freezer shares from the growth shares by holding the growth shares in a discretionary trust allows the value of the growth shares to be unaffected by the increase in balance sheet value of the company, for example by rising house prices. With careful drafting of the company shareholders agreement this can prevents the value of the discretionary trust from increasing to a point where it could become subject to tax.
You may already have wills in place, but these must be reviewed to ensure the structure remains intact for the next generation, i.e. so that your beneficiaries then have control of the company in terms of voting rights and dividends, but the value of the business also continues to accrue outside of their estate for Inheritance Tax “IHT” purposes. That provides your beneficiaries with control over whether to continue the business after you have died and to declare dividends to themselves, or to liquidate the company and benefit from the discretionary trust as, explained above.
Lasting Powers of Attorney “LPAs” are also vital for landlords. The law works on the basis that if you do not have an LPA, in the event of you being unable to make your own decisions, the Office of the Public Guardian will make decisions for you. Can you imagine being in a coma and your spouse and/or family being powerless to make important decisions, such as whether to turn off life support, or to evict your tenants and sell your properties? Without an LPA, a Civil Servant makes those decisions for you.
In a perfect world, you would simply be able to transfer your existing properties into your Family Investment Company structure without having to worry about any tax implications. This is referred to as ‘incorporation’.
However, real life is never that simple.
Incorporation might result in you having to pay Capital Gains Tax, because the transfer could be regarded as a sale of investment assets. Also, your company might have to pay Stamp Duty Land Tax to acquire the properties.
For established property rental businesses, there is a form of rollover relief called ‘incorporation relief’ available to reduce or completely negate Capital Gains Tax at the point of incorporation. Essentially, the capital gains are rolled into the shares of the company into which the business as a whole is being transferred as a going concern.
Likewise, legislation exists to minimise or completely negate the Stamp Duty problem (SLDT in England / LBTT in Scotland / LTT in Wales), but only for established business Partnerships.
With careful planning, transfers between various ownership structures can occur without Capital Gains Tax or Stamp Duty falling due. The key to this planning is to ensure that you do not fall foul of a piece of legislation called G.A.A.R. “General Anti Abuse Rules”, or other anti-avoidance legislation.
For example, if you were to form a Partnership for a very short period of time, simply to avoid paying Stamp Duty at the point of incorporation, HMRC has the power to disregard this and treat it as a contrived series of stepped transactions.
However, if there are legitimate reasons for forming a Partnership, that’s fine, so long as it is clear that the whole process is not just a sham.
For example, a genuine commercial reason for forming a Partnership is ‘business continuity planning’ might be that the founders of a business wish to bring their adult children into the business with the expectation of them taking over the running of the business when the founders wish to retire.
The legal definition of a Partnership is ‘two or more persons engaged in business with a view to profit’.
A Limited Liability Partnership “LLP” is both a business and a Partnership, because it is registered at Companies House and has the same filing obligations as a limited company.
As the name suggests, LLPs carry limited liability status too, which is one of the many reasons we often recommend them over ordinary Partnerships, despite the fact that accounting and compliance is slightly more onerous and costs a little, although not significantly, more.
Members of an LLP are usually allocated profit share proportionate to their capital account balance. However, disproportionate allocation of profit may be achieved by allocating Individual Members a ‘partner’s salary’ in recognition of the work they do on behalf of the partnership. For example, a spouse may contribute little or no equity, but take on a significant share of the management of the business. The primary benefit of this approach is to optimally utilise all lower rate tax bandings of individual Members.
In very simple terms, for every £10,000 of profit allocated to a nil rate tax-payer as opposed to a 40% tax-payer, the saving is £4,000. Likewise, for every £10,000 of profit allocation to a basic rate tax-payer as opposed to a 40% tax-payer, the saving is £2,000.
An LLP is transparent for tax purposes, which means that so long as the LLP’s opening Capital Account balance for each member reflects the market value of the equity in the properties, there are no consequences in regard to Capital Gains Tax or Stamp Duty Land Tax. This can be achieved by legally documenting the economic beneficial interest in rental properties that are held ‘on trust’ for the LLP.
There is no requirement to refinance or even obtain consent from mortgage lenders because the legal ownership of the properties, the existing mortgage contract terms and the lender’s security all remain completely unchanged.
Operating the business of letting your properties through an LLP should not hamper your ability to raise mortgage finance whatsoever. Quite the opposite in fact, it could actually improve the availability of mortgage finance, because you will continue to own the existing properties personally and be able to obtain finance just as you have always done. However, mortgages can be applied for by any one, or a combination, of the LLP Members, because they can hold the property ‘on trust’ for the LLP. Equally, if you choose to, you could raise mortgage finance in the name of the LLP itself, as it is a separate legal entity. Whilst this is less common, some mortgage lenders have buy-to-let mortgage products specifically designed for LLPs.
We commonly recommend the opening Capital Account balance for each Member to be the value of the net equity in their share of beneficial interest in properties transferred to the LLP. There are a few reasons for this.
It is permissible for one or more new Members to join the Partnership at the outset or at a later date with a zero Capital Account, providing they do at least some work in the business. There is no requirement for them to be able to do everything necessary to run the business, providing that they have a role within it. Likewise, a person might only introduce capital, in which case they would be deemed to be a ‘sleeping partner’.
An LLP must be incorporated with at least two ‘Designated Members’. Other Members, if there are any, may be referred to as ‘Non-designated Members’ or ‘Ordinary Members’. There is no upper limit on the number of LLP Members.
A Designated Member will command the same rights and responsibilities as a Non-designated Member, with the following exceptions.
According to HMRC’s Partnership Manual https://www.gov.uk/hmrc-internal-manuals/partnership-manual/pm132050 (our emphasis added):
“There are few restrictions on who can be a partner.”
AND
“It is not a requirement of a partnership that each member is physically capable of performing the full range of the activities of the partnership business, but each must be capable of performing a part of the activities, even if that role is only to provide finance. A partner who plays no active part in the business but has contributed capital is often described as a ‘sleeping partner’.
“Spouses and civil partners can enter into partnership with each other. Sometimes this is done for tax planning reasons as it may be advantageous for a person to share their business profits with his or her spouse to maximise the use of their personal allowances and basic rate tax bands. HMRC is unlikely to challenge such an arrangement.”
According to HMRC’s Partnership Manual https://www.gov.uk/hmrc-internal-manuals/partnership-manual/pm132400 (our emphasis added):
“A spouse or civil partner is sometimes taken into partnership wholly or mainly to maximise the benefit of the tax reliefs that are available.”
“You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners’ contribution to the firm’s activity. It may be possible in these cases to challenge the spouse or civil partner’s status as a partner, but such a challenge can be difficult to sustain. It is sometimes overlooked that there is no need for the spouse or civil partner to contribute capital; or to participate in management; or, in a trading context at least, to be capable of performing the main activity of the business. Indeed to be a partner one need not take an active part in the business at all. Where the spouse or civil partner has signed a deed declaring an intention to carry on the business and the deed gives a right to share in the profits, and subsequently the accounts of the business show that that person has been allocated a share of the profits, there will not usually be much chance of mounting a successful challenge.”
“It is worth emphasising that a partnership is not a sham merely because it is set up to save tax, as indeed the spouse or civil partner who is deserted by a partner leaving them to meet the firm’s liabilities may at their own cost. There will always of course be some cases which will be worth investigating and challenging, but these are more likely to be found among those where there is no current partnership deed, and particularly where there is a clear attempt to antedate the setting up of a partnership by more than a few months.”
If you are currently employing members of your family then you will be paying employers National Insurance Contributions “NIC” and they will be paying employees NIC. If they are self-employed contractors, they will be paying Class 2 and Class 4 NIC. However, if they were to become Members of a Property Investment LLP they only pay Class 2 NIC and no further NIC would be due whatsoever.
Making children Members of an LLP will not require them to own property. Therefore, their ability to claim First Time Buyers Stamp Duty relief will remain unaffected. However, their share of profit allocation will improve their ability to obtain mortgages if/when they do decide to purchase their first home.
The following case study explains how a private landlord managed to use an LLP structure to facilitate a substantial reduction in tax for his family.
Mr X has a property rental business in his own name, which produces real profits of £100,000 a year, but taxable profits of £200,000 after factoring in the restrictions on finance cost relief. Let us also assume that he has an income of £150,000 from another profession or trading company. However, his wife has no earnings and neither do his three adult children who are studying at University but already showing an active interest in the property business and wanting to get more involved when they can.
In this scenario, it would be fair to say that income tax, inheritance tax and legacy planning are very much ‘on the mind’ of Mr X.
By transferring the beneficial ownership of his property rental business into an LLP, his opening ‘Capital Account Balance’ would be the value of his properties minus the liabilities, i.e. his mortgages. This can be achieved without remortgaging and reliefs exist to ensure that Capital Gains Tax and Stamp Duty do not fall due either, as explained at the beginning of Section 3.
His wife and his children can then become Members of the LLP, because they all have an active interest in the business. The opening value of their Capital Accounts is £nil, because they have not contributed anything to the business at that stage.
The purpose of the restructure goes far beyond income tax planning, because succession planning is also an important consideration.
A year later, the business has produced the same profits as before, i.e. £100,000 of real profit and £200,000 of taxable profit after factoring in the restrictions on finance cost relief.
Previously, Mr X would have paid tax as follows:
This represents a tax bill of 70% of the real cash profit of the rental property business.
However, under the new structure, now that his wife and three children are taking a more active role in the rental property business, the taxable profits are allocated differently. Mr X takes none of the profits and instead allocates £50,000 of taxable profit as a ‘Partners Salary’ to his wife and each of his three children.
As they do not have any other taxable income, they can utilise their full personal allowance and pay only basic rate tax on the remainder.
The total tax ordinarily payable under the new structure is just £30,000.
So, whose money is it now?
After paying the tax, the Capital Account values of the wife and the three children now stand at £42,500 each. A well-drafted LLP Members Agreement can determine that drawings from the business are at the discretion of the Senior Partner, e.g. the person with the highest value Capital Account, or indeed until the death of the founder of the business. The Senior Partner could, of course, allow drawings to be taken by other Members if he chooses to do so. He might, for example, agree to this if the incoming Member’s work results in the profitability of the business increasing as a direct result of their efforts.
Assuming no other drawings are taken by his wife and children, save for the money needed to pay their tax bills, the LLP bank account would have accumulated £60,000. That is £40,000 more than would previously have been the case without this structure.
The Senior Partner could, if he wished to do so, withdraw and spend all the cash in the bank. This would be recorded as a debit against his Capital Account, the outcome of which is that his Capital Account would reduce.
Over time and assuming he lives long enough, it is quite feasible for Mr X to have reduced the value of his Capital Account to zero. Meanwhile, the Capital Account balances of his family Members would be growing very nicely indeed. A further benefit of this is that when Mr X eventually passes away, the net value of his estate for Inheritance Tax purposes will also be significantly lower than it would otherwise have been, because the value of his property rental business would have been transferred to the next generation.
You should seriously consider the sale of an established property rental business Partnership as a going concern to a Family Investment Company Structure if any one or more of the following apply to your circumstances.
Arguably, one of the best tax-related reasons to consider incorporation is that incorporation relief can ‘wash out’ some or all capital gains to date’, by rolling capital gains into the shares of your company.
This means that you could sell any number of your properties after incorporation at market value without having to pay any Capital Gains Tax “CGT”, for example; if the company was selling them for the same price as it acquired them. This is particularly useful if you want to use net sale proceeds to pay down debt, or if you would like to sell any poorly performing properties and utilise the proceeds of sale to purchase other properties with better returns.
When you sell property, or your business as a whole, you would ordinarily crystallise any capital gains. Your capital gains are calculated by deducting the acquisition costs of your properties from the current market value of your properties. Please note that your acquisition costs are not necessarily just the purchase price of your properties; you also need to factor in any other capitalised costs, i.e. those which have not already been offset against rental income. These might include extensions to buildings, lease extension premiums, Stamp Duty paid or professional fees in regards to the capital structure of your business.
The value of your shares would ordinarily be the value of your equity, i.e. properties and other assets minus mortgages and any other liabilities. The way that incorporation relief works is that the value of your shares is offset against your capital gains.
In regards to your eligibility to claim ‘incorporation relief’, HMRC’s manual cg65700 says: –
“TCGA92/S162 applies where a person other than a company transfers a business as a going concern with the whole of its assets (or the whole of its assets other than cash) to a company wholly or partly in exchange for shares. Provided that various conditions are satisfied, see CG65710, the charge to CGT on the whole or part of the gains will be postponed until such time as the person transferring the business disposes of the shares.”
The way the relief works in practice is that all or part of the gains arising on the disposals of the assets are ‘rolled over’ against the cost of the shares.
Relief under TCGA92/S162 is sometimes referred to as ‘incorporation relief’.
A key factor in regard to your eligibility to utilise ‘incorporation relief’ is that it is only applicable if you are running a business.
HMRC’s definition of a business, which is based on case law, is that:
HMRC’s manual CG65715 says:
You should accept that incorporation relief will be available where an individual spends 20 hours or more a week personally undertaking the sort of activities that are indicative of a business. Other cases should be considered carefully.
When you transfer your business to your company you will be exchanging your equity for shares. It is the value of these shares that your capital gains are rolled into.
If the value of shares created is less than the amount required to absorb your capital gains you would still have Capital Gains Tax to pay on your “latent gains” (the amount by which your mortgages exceed your base costs).
Solutions to mitigating this tax are as follows.
Mistake #1 – advising clients to arrange new financing in the company name at the point of incorporation.
The Chartered Institute of Taxation “CIOT” wrote to HMRC about this in February 2024 – details here
The CIOT letter reminded HMRC of their Extra Statutory Concession ESC/D32, the roots of which can be traced back over 50 years.
Property118 has been warning landlords of the risks associated with arranging new financing at the point of incorporation since 2015. The possible pitfalls associated with doing so are that HMRC could argue that liabilities are not “taken over” and any cash received from the company to repay existing mortgages could be regarded as cash consideration and subjected to Capital Gains Tax.
HMRC’s own manual CG65745 makes it quite clear that liabilities are “normally” expected to be “taken over” in the form of an “indemnity”. The only ambiguity, albeit seemingly quite a shallow argument, is whether HMRC should, in the future, regard new replacement lending as liabilities “taken over” rather than as a “consideration” that attracts CGT.
Not only does the letter from CIOT make these points even clearer to HMRC, but they also quote guidance that can be found in the leading tax law text books published by Lexis Nexis, in particular Simon’s Taxes, which includes the following paragraph: –
“The incorporation of a buy-to-let property business may involve refinancing the existing mortgages which could possibly prevent HMRC applying ESC/D32. If the company does not assume the same liabilities of the transferor, but instead raises finance of its own, which is passed to the transferor to settle its debts related to the properties being transferred, there is considerable risk that HMRC might choose not to apply its concession.”
Nobody has ever said that incorporation is tax avoidance, but far too many advisers miss one critical point; the method of incorporating a rental property business recommended by Property118 does not result in a single penny of tax advantage over and above what HMRC’s 50+ year old concessions and Government legislation intended.
In the absence of any additional tax advantages, how can a tax avoidance scheme possibly exist?
There are commercial advantages, such as not having to pay early repayment charges or switching to higher interest rates, but this puts more cash into the pockets of both the Exchequer and the incorporating landlords, so what is the problem with that?
The following is a worked example of the above to make the point clear:
As a result of the company providing an indemnity for the 5% private BTL mortgage interest the profit of the company exposed to corporation tax would be £20,000 and the company would be £20,000 a year better off. However, if the private financing was paid off with company financing at a rate of 7% there would be no profit remaining to be subjected to taxation.
Some critics have even gone as far as to suggest that the indemnity payments would not attract tax relief for the company and/or the payments would be taxable in the hands of the recipient. This utter nonsense can be explained in layman terms by way of the following simple example.
An employee needs to pay for a business trip hotel bill using their personal credit card. The company reimburses the employee when they hand over the receipt from the hotel. The company claims the hotel bill as an expense and the employee receives funds to repay their credit card. Naturally, nobody expects the employee to pay tax on that money. It’s a very similar situation using the same principles here. The landlord pays the mortgage lender the agreed monthly repayments, and the company reimburses the landlord based on the indemnity it gave when taking over the responsibility to service and eventually repaying the debt.
For those with a penchant for reading the applicable legislation, see S.330A(4) CTA 2009:
“… the amounts recognised as mentioned in subsection (1)(a) [i.e. deductible from profits under the loan relationship rules] are recognised as a result of a transaction which has the effect of transferring to the company all or part of the risk or reward relating to the qualifying relationship without a corresponding transfer of rights or obligations under the relationship”
This is amplified in HMRC manual CFM33275 where an example of applicability given is:
Condition B – transfers of risk and reward
Parties may enter into contractual arrangements that transfer all or part of the risk and reward for being party to a debt, without a legal transfer of the debt itself. Where this happens, the debt may for accounting purposes be wholly or partially derecognised (or not recognised) by one party and wholly or partly recognised by another.
An example might be a defeasance transaction where one company agreed to take over the obligation to service a debt but without a novation of the debt. In that event S330A would enable the party to whom the obligation was transferred to take into account amounts arising from serving the debt.
Sources:
Mistake #2 – failure to advise clients to withdraw their positive capital account balances prior to incorporation, even if it requires the business to arrange commercial financing to provide the liquidity to make this possible.
A positive capital account balance exists when a business owner has left capital in the business and has not yet withdrawn it, or financed its withdrawal.
It is important to bear in mind that positive capital account balances have already been subjected to taxation. They occur as a result of initial and ongoing investment into the business by its owners, either from injections of capital already taxed or profits of the business on which tax has already been paid but where those profits have not been extracted yet by the owners. Therefore, the owners of an unincorporated business are at liberty to withdraw those funds at any point in time without being subjected to taxation yet again.
The problem for many landlords is that their positive capital account balances are illiquid. However, HMRC manual BIM45700 does acknowledge that it is perfectly acceptable for an unincorporated business to arrange financing to correct this position. This is also acknowledged in the letter from CIOT to HMRC referred to in my first point above. Furthermore, withdrawing positive capital account balances prior to incorporation is also advocated as best practice in the Lexus Nexis textbooks.
The consequence of leaving positive capital account balances in the business at incorporation is that the funds are then rolled into share capital. The problem with this is that the withdrawal of funds from the company would be subjected to taxation yet again.
Guidance within the Lexis Nexis tax law text book Simon’s Taxes states at B9.112:
If there is a substantial capital account in the unincorporated business, the business owner(s) should be advised to draw this down before incorporation, otherwise that capital will be locked into the value of the shares.
The above cannot possibly be regarded as tax avoidance, because tax has already been paid on the positive capital account balances. Who in their right mind would elect to proceed down a path whereby they would knowingly be subjected to another unnecessary layer of taxation on money that has already been taxed?
The basis of these arguments was tested at Court in IRC v Brebner [1967] 43 TC705, when Lord Upjohn said:
When the question of carrying out a genuine commercial transaction, as this was, is considered, the fact that there are two ways of carrying it out – one paying the maximum amount of tax, the other paying no or much less tax – it would be quite wrong as a necessary consequence to draw the inference that in adopting the latter course one of the main objects is, for the purposes of the section, the avoidance of tax. No commercial man in his senses is going to carry out commercial transactions except upon the footing of paying the smallest amount of tax involved.
The above quote can, to this day, still be found in HMRC manual CFM39520.
There are commercial advantages that can be leveraged with this form of planning too, without creating a further tax advantage. For example, in many cases it pays to borrow funds for the shortest time possible to avoid paying interest. That’s not tax avoidance, it is common sense, particularly if interest required to service any additional borrowing costs cannot be immediately deployed to earn a higher rate of return.
Any new debt arranged by an unincorporated business becomes a liability of that business. Accordingly, it can be “taken over” by the acquiring company in the form of an “indemnity” at the point of incorporation as explained in my first point.
Post incorporation, the owners of the business may well choose to make directors loans to their company. Likewise, the company may use any such funds to redeem liabilities it indemnified at the point of incorporation.
There is no legislation for the above so Property118 has taken the same view as CIOT in terms of ESC/D32 as explained in HMRC Manual CG65745. Importantly, there are no timescales quoted for the debt to remain in place, so theoretically, the transactions could occur within seconds on either side of the incorporation being substantially performed. In practice, it obviously takes a bit longer but it is certainly not unheard of for all such transactions to be performed on the same day.
Where business owners are immediately able to deploy capital released by the unincorporated business to produce higher returns than their costs of financing they are, of course, free to do so. In this case, it would be logical and commercially beneficial for them to arrange new longer-term financing in the company name as soon as possible in order to repay the more expensive short-term debt that the company indemnified at incorporation. This would enable the business owners to retain/reinvest their cash elsewhere.
Mistake #3 – misunderstanding beneficial interest.
Legislation, HMRC’s manuals, and the leading tax law text books all make it very clear that taxation follows beneficial interest rather than legal ownership. Furthermore, substantial performance is recognised in all of the above.
HMRC manual SDLTM07700 states:
“Broadly, substantial performance is the point at which
The legislation in regards to Capital Gains Tax is TCGA92/28(1), which states:
… where an asset is disposed of and acquired under a contract the time at which the disposal and acquisition is made is the time the contract is made (and not, if different, the time at which the asset is conveyed or transferred).
Sources:
Mistake #4 – lender security misunderstandings.
The security of legal charges taken by mortgage lenders is protected by the Law of Property Act 1925 regardless of whether business sale and purchase contracts are substantially performed by transferring beneficial interests alone.
If you have more equity in your portfolio than you would need to exchange for shares to wash out capital gains, this is money that you have personally invested into the business from funds that have already been taxed, or has resulted from paying down finance using taxed money.
It may well be that you don’t need that money now and if that is the case you probably don’t want to go to the expense or the trouble of refinancing and being tied into new mortgage deals either.
This is how the Capital Account Restructure can work:
Financing of this nature must be arranged commercially at arm’s length and must be transacted in the correct order. Likewise, a clear audit trail of the flow of funds is imperative. The involvement of your accountant is usually required to calculate the optimal level of new financing.
The outcome of this restructure is that the company will owe you money in the form of a directors loan. When the company accumulates cash, it can begin to repay the directors loan to you. Such repayments do not attract personal taxation.
There are several ways the company can accumulate cash, including:
An exemption against paying Stamp Duty Land Tax “SDLT” automatically applies when a business partnership transfers its ‘whole business’ to a company at the point of incorporation.
The applicable legislation in England is FA2003/sch15, as amended by FA2004/Sch41.
The Partnership Act 1890 section 1 describes a partnership as:
“the relation which subsists between persons carrying on a business in common with a view of profit.”
If you operate your property rental business in partnership with one or more other people and share risks and rewards as ‘co-adventurers in business’, you might legally be operating a Partnership, despite not registering it with HMRC.
The existence of a Partnership is a matter of fact, so if this applies to you, your accountants should have advised you to register the Partnership with HMRC and submit SA800 Partnership Returns.
However, if you are a Partnership but have not registered with HMRC, given that you would have paid no more or less tax as a result of this, HMRC is likely to take a pragmatic view on oversights of this nature. The reason for this is that property investment was not regarded as a business activity by HMRC until they lost their case against Elizabeth Moyne Ramsay in the Upper Tier Tax tribunal in 2013. That case wasn’t widely publicised until much more recently, so in fairness to your accountants, that may well be why they wouldn’t have thought to register your Partnership with HMRC.
There is no substitute for bespoke professional advice, so please DO NOT take any action based on the contents of this eBook without completing a full tax planning consultation with us.
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