With 6 April fast approaching, many property landlords, especially those planning to expand their portfolios, will be wondering whether it is better to incorporate.
The obvious advantages of incorporation are lower than income tax corporation tax rates (set to fall even further in future), the continued tax relief on mortgage interest for companies (now restricted and eventually denied to private landlords), and much more flexibility regarding the timing of the extraction of profits and hence more tax planning opportunities, with the added benefit of a £5,000 extraction tax free in the form of dividends.
However, transferring properties to a limited company has a number of tax consequences on incorporation.
Like any transfer of assets between connected parties, the transaction is deemed to have taken place at market value (MV), hence the transfer of properties from a private landlord to his/her newly incorporated company will create taxable capital gain on the landlord.
Availability of capital gains tax reliefs
The recently introduced lower capital gains rates of 10% and 20%, the entrepreneur’s relief and gift relief are not available on incorporation of a rental property business.
However, incorporation relief is likely to be available in the following circumstances:
The relief is also available to partners where the whole business of the partnership is transferred to a limited company.
The consequence of incorporation relief is that the cost base of its shares for capital gains tax purposes is reduced by the amount of the gain relieved on incorporation, hence deferring the tax liability until the company is sold. In theory, if the company is never sold, capital gains tax will be deferred indefinitely.
Incorporation relief applies automatically, so is not claimed. If incorporation relief is not beneficial, it can be disclaimed.
This is highlighted in Elizabeth Moyne Ramsey v HMRC  UKUT 266.
In Elizabeth Moyne Ramsey v HMRC  UKUT 266 TC the Upper Tier Tax Tribunal ruled that residential property letting is a business for the purposes of roll-over relief under s162 TCGA 1992 (incorporation relief).
HMRC has long argued that ordinary letting cannot usually be regarded a business and that an increase in the level of activity undertaken to run a letting venture is not evidence that it is a business; instead, it is simply commensurate with the investment property portfolio increase in size.
The upper tribunal ruled that property letting can be a business for the purposes of incorporation relief and that whether or not it is is a question of fact. It is a business if the letting activity has the characteristics of a business, specifically if it is:
The tribunal found that ‘in the context of property investment and letting, the same activities are equally capable of describing a passive investment and a property investment or rental business’. The key differentiator of whether or not letting is a business is ‘the degree of activity undertaken’.
The upper tribunal specifically refused to identify any specific threshold of activity by reference to a given number of hours or days spent on letting-related activities. However, it indicated that the degree of activity should outweigh what might normally be expected to be carried out by a mere passive investor.
HMRC’s own interpretation of the judgment at CG65715, however, does impose a minimum threshold of 20 hours per week, as per the particulars of the Ramsey case:
‘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.’
Non-statutory clearance can be obtained from HMRC on specific transactions, by writing to HMRC Non-Statutory Clearance Team at Southend on Sea, quoting Annex A of HMRC’s non-statutory clearance technical guidance to identify the most probable classification in the eyes of HMRC.
Transfer of properties from an individual to a company
No special relief is available for property transferred on the incorporation of an individual proprietor’s existing business.
SDLT arises on the MV of the properties transferred (s53, FA 2003), irrespectively of consideration actually paid. For companies, for transactions completed on or after 1 April 2016 on which contracts were exchanged after 25 November 2015, SDLT at higher rates (3% surcharge) apply if the chargeable consideration is £40,000 or more and where the dwelling is not subject to a lease with more than 21 years left to run.
In the event that the properties transferred to the company are short leaseholds (granted for 21 years or less), multiple dwelling relief (MDR) can reduce SDLT. If MDR is claimed, higher SDLT rates apply for the purposes of the calculation and at least two dwellings need to be transferred. The total SDLT payable is calculated on the mean consideration using the relevant higher SDLT rates multiplied by the number of dwellings. The actual SDLT payable is the higher of that amount, and 1% of the total consideration.
If the portfolio transferred is made of at least six dwellings, the company can choose whether to pay SDLT at the higher rates and apply MDR, or treat the properties as non-residential and apply relevant rates applicable to non-residential properties, but without MDR.
Transfer of properties from a partnership to a company
Companies incorporated from a partnership may significantly reduce or eradicate its SDLT bill altogether, thanks to special rules granting SLDT exemption in transactions between a partnership and persons connected with the partnership (Part 3 Schedule 15 FA 2003).
Applying CTA 2010, s1122, an individual who is a partner in a partnership, and a company controlled by that same individual, are connected parties.
Essentially, as long as the controlling shareholder(s) of the company created on the partnership’s incorporation have held all of the interest in the partnership before incorporation (taking into account the individual’s share in the partnership and any of his/her relatives who were also partners), the company will escape SDLT.
However, if an individual now holding majority of shares in the company has been in partnership with unrelated individuals, it is only a proportion of the share consideration issued by the company for the properties of the partnership which will escape SDLT.
See an example at ACCA's technical advice and support pages.
For example, a property business partnership is run by Mr A (entitled to 70% of profits) and Mr B (entitled to 30%). The partnership incorporates into AB Ltd (70% held by Mr A and 30% held by Mr B) and the property (MV of £100,000) is transferred to AB Ltd. Only Mr A is connected with AB Ltd as he has control. To identify a possible reduction in SDLT, you need to establish how much interest the person who now has control of AB Ltd (Mr A) was entitled to in the partnership. In this case, Mr A was entitled to 70% of the partnership’s interests. This means that 70% of the MV of the properties transferred (consideration) will escape SDLT. The remaining 30% will be subject to SDLT.
The legislation refers to this as the sum of lower proportions (SLP): proportion of ownership of the property’s relevant owner after the transaction (the company – owning 100% of the property) and before the transaction by the person who now controls the company and before was a partner and anybody related to them (in the above example: 70%). The lower of 100% and 70% is 70% (SLP). When applied to a formula which determines MV for the calculation of SDLT, MV of consideration on which SDLT would arise is:
MV x (100-SLP) %
The proportion of the MV consideration on which SDLT would arise is:
£100,000 x (100-70)% = £30,000.
Anti-avoidance legislation applies in cases where a partnership is created with a sole purpose to avoid SDLT.
Considering the complications of incorporation, some of which are discussed above, is it worth it?
A detailed comparison of tax costs impacting an incorporated vs unincorporated business throughout its business is deserving of much extended page space than available here.
However, tax impacts alone should not determine the final decision on incorporation or otherwise. Practical considerations, such as a lender’s consent to move properties to a company, potential need for refinancing following incorporation, its cost and additional bank requirements (such as personal guarantees demanded of shareholders), are likely to influence the final decision.