Many landlords introduce properties into their rental businesses, which may have already been held for some time (e.g. gifted or inherited property). Those landlords are, in effect, introducing capital into the business, broadly equal to the market value of the property when it was introduced, less any outstanding mortgage, etc.
HM Revenue and Customs (HMRC) guidance in its Business Income manual (at BIM45700) states that a business owner “may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business.”
Some property business owners may have previously (based on HMRC’s guidance in BIM45700) borrowed up to the value of a property when it was introduced into the property rental business, used the proceeds for a non-business purpose (e.g. cars, holidays), and claimed a deduction for the interest paid against rental profits. However, there was anecdotal evidence in 2017 of HMRC resisting interest relief claims for additional borrowings, unless those funds were used in the property business.
Following the introduction of a restriction in the deduction of interest and other finance costs related to residential property businesses, which applies to individual landlords from April 2017, some potentially affected landlords have considered incorporating their property rental businesses, as the restrictions on loan interest relief etc. do not apply to corporate landlords. However, incorporation could give rise to a capital gains tax (CGT) trap in certain cases.
For CGT purposes, the transfer of rental properties to a company upon incorporation will normally be treated as a disposal at market value. If the properties are standing a large capital gain, this could be a major obstacle to incorporation. However, CGT relief may be available in some cases.
The main form of CGT relief in these circumstances is rollover relief on the transfer of a business (e.g. a residential property rental business), commonly referred to as ‘incorporation relief’ (TCGA 1992, s 162).
Incorporation relief is subject to certain conditions, which are beyond the scope of this article. However, if the relief applies, the effect is broadly that the property gains attributable to the consideration received in the form of the company’s shares are deducted from the cost of those shares (i.e. the gains are effectively ‘rolled over’ and deducted from the cost to be allowed on a subsequent disposal of the shares).
The relief is potentially restricted to the extent that the company pays for the business. ‘Payment’ for these purposes can include the company taking over the business owner’s liabilities. However, by concession, HMRC does not restrict incorporation relief if business liabilities (e.g. property loans) are taken over by the company (see extra statutory concession D32).
However, the property gains that can be rolled over in this way cannot exceed the cost of the shares. For example, if the market values of the properties (plus other business assets) only marginally exceed liabilities, the base cost of the shares may be negligible. This could result in the amount of incorporation relief being restricted, and CGT immediately becoming due.
Suppose that a landlord (perhaps having read
BIM45700) borrowed up to the value of the properties he introduced into his property rental business. He now wishes to incorporate the business. However, his properties are standing at a substantial capital gain. If the value of the business assets (i.e. mainly the properties) and liabilities (i.e. the property loans) taken over by the business are broadly similar, his shares in the company might only have a nominal value. Consequently, even if the business transfer is eligible for incorporation relief, the gains rolled over against the cost of the shares are likely to be minimal. A CGT liability would therefore arise in the tax year of incorporation.
Outstanding borrowings and CGT reliefs are only two issues to consider. The decision whether to incorporate a property rental business must take both tax and non-tax implications into account, and care is needed.
The above article was first published in Tax Insider in May 2017 (www.taxinsider.co.uk).