Before delving into the details of Property118’s strategy and the criticisms raised by Tax Policy Associates(Dan Neidle), it’s important to note the backdrop of changes in UK tax regulations affecting buy-to-let landlords.
These changes, particularly those related to mortgage interest deductions, have made traditional buy-to-let investments less tax-efficient, leading to the exploration of alternative strategies, including the use of limited companies.
Background on Tax Changes for Buy-to-Let Landlords
Many buy-to-let landlords in the UK traditionally held their rental properties personally. They paid income tax at rates of 40% or 45% on the rental income they received. However, up until 2017, they were able to deduct the interest they paid on their mortgages from their taxable income. This was a significant tax benefit.
In 2017, the government introduced changes that gradually reduced the ability to deduct mortgage interest. Instead, landlords received a 20% tax credit on their mortgage interest payments. This change made owning rental properties more expensive for many landlords.
One strategy to mitigate this increased tax burden was to hold rental properties within a company. Companies in the UK typically face lower corporation tax rates, often below 25%. Additionally, companies are still eligible for full tax relief on mortgage interest payments.
However, transferring properties from personal ownership to a company isn’t straightforward. There can be capital gains tax implications when moving properties into a company, and stamp duty land tax (SDLT) may also apply.
Perhaps the most significant challenge is that most mortgage lenders do not allow existing individual mortgages to be transferred to a company. While it is possible to obtain a new mortgage for a company, these mortgages tend to be more expensive than traditional buy-to-let mortgages.
As a result, financial advisers often caution their clients that the increased interest cost associated with transferring properties to a company can outweigh the tax savings. It’s essential for landlords to consider these factors carefully and not be solely focused on the potential tax benefits.
Property 118 Strategy
Property118 proposes a strategy they call the "Substantial Incorporation Structure" to help buy-to-let landlords retain the tax benefits of moving properties into a company while keeping their existing mortgage agreements intact.
Here's how this strategy works:
Setting Up a New Company
The landlord, referred to as "X," establishes a new company (referred to as the "Company").
Property Transfer
X sells their rental properties to the Company in exchange for shares in the Company.
Deferred Completion
Importantly, the actual completion of the property sale is deferred, meaning X continues to be the registered owner of the properties.
Creation of a Trust
A trust is established, with X acting as the trustee, and the Company as the beneficiary of this trust.
Hidden Transaction
This entire process is kept hidden from both the public and the mortgage lender. X does not seek consent from the mortgage lender or inform them about the transfer.
Property118 argues that because this transaction creates a trust, it does not breach X's mortgage agreement. They claim that "incorporation relief" applies, ensuring that there is no capital gains tax liability.
Additionally, they often argue that if X and their spouse were in a partnership, the rules governing partnerships apply to avoid stamp duty land tax (SDLT) liabilities.
Mortgage Payments
X continues to make mortgage payments to the lender as usual. However, behind the scenes, the Company agrees to reimburse or indemnify X for these payments.
The Company claims tax relief for these payments, effectively making it as if the Company had borrowed the money itself.
Smart Company Shares
Property118 suggests that the Company issues shares to X's children, which are initially considered to have no value but are expected to increase in value over time.
This arrangement is designed to ensure that any future increase in the value of the property portfolio falls outside of X's inheritance tax estate.
Capital Gains and Incorporation Relief
1. X's Potential Capital Gain
- X may have a substantial latent capital gain in their property portfolio.
- For instance, if X bought the portfolio for £4m and its current market value is £8m, the capital gain would be £4m, resulting in a potential £1.12m Capital Gains Tax (CGT) liability.
2. Property118's Claim of Incorporation Relief
- Property118 asserts that their Substantial Company Incorporation Structure qualifies for CGT Incorporation Relief.
- This relief offers two significant advantages for X: no CGT on the transfer to the Company and the capital gain is "rolled over" into Company shares, eliminating tax on the latent capital gain in the properties.
3. Doubt Surrounding Incorporation Relief
- Incorporation Relief's eligibility criteria require the entire business's assets to transfer to the Company.
- However, it appears that legal title to the properties remains with X, which is a crucial issue.
- The absence of legal title affects the Company's ability to borrow, refinance, and sell properties, posing a significant constraint on its operations.
- This implies that the Company did not acquire the "whole assets of the business," raising doubts about the application of incorporation relief.
4. Not a Transfer of a "Business as a Going Concern"
- The situation appears to involve an economic transfer under a trust rather than a transfer of a "Business as a Going Concern".
- The actual operation of the "business" continues with the person holding legal title, handling tenant interactions, banking, and other aspects.
- In essence, the "business" doesn't seem to be moving to the Company.
5. Likelihood of Incorporation Relief Not Applying
- Considering the issues related to legal title and the absence of a genuine transfer of the business, it is likely that incorporation relief does not apply.
- In some cases, there may also be uncertainty about whether X's activities as a landlord constitute a "business" as defined in the relevant legislation.
In summary, while Property118 promotes the idea of CGT incorporation relief as a benefit of their structure, doubts arise due to the failure to transfer legal title and the absence of a genuine transfer of the business.
These uncertainties suggest that incorporation relief may not be applicable in this context.
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Stamp Duty Land Tax (SDLT) and Related Considerations
1.SDLT on Property Transfer
- Under normal circumstances, Stamp Duty Land Tax (SDLT) is due on the transfer of properties by X to the Company at the full market value.
- The tax rate can be as high as 15%, potentially resulting in a significant upfront tax cost.
2.Relief for Partnerships Incorporating
- Partnerships have relief available when incorporating, but this relief is not extended to individuals incorporating their property businesses.
3.Property118/Cotswold Barristers' Solution
- Property118 and Cotswold Barristers propose a solution for couples running a property rental business together.
- They claim that the couple has always operated as a Partnership, making partnership relief available.
- This claim is made even in cases where there is no formal partnership agreement, partnership tax returns, or clear evidence of an existing partnership.
- Establishing the existence of a partnership in such situations can be challenging, as shown by the recent SC Properties case.
- The burden of proof falls on the taxpayer, and the legal distinction between spousal relations and business partnerships is crucial.
4.Success of SDLT Relief Strategy
- This strategy is likely to succeed in only rare cases where SDLT relief is applicable.
- HMRC guidance indicates that HMRC may contest such claims.
5.SDLT Relief and Penalties
- If SDLT were to apply because properties do not qualify as partnership property, interest and penalties for late filing could become due.
- While Multiple Dwellings Relief could potentially reduce the SDLT charge, this relief must be claimed in a return or an amendment to a return.
- An SDLT return cannot be amended more than one year after the filing date for the transfer.
- If any property was occupied by X or his relatives or not held for a qualifying business purpose, a higher SDLT rate of 15% could apply.
6.Annual Tax on Enveloped Dwellings (ATED):
- Enveloped Dwellings (ATED) would not be payable if the properties are let out to third parties.
- However, ATED Relief must be claimed, and it is unclear if Property118 advises their clients to file ATED returns.
- Failure to file ATED returns can result in late-filing penalties of up to £1,600 per return per year.
- Companies using these arrangements over five years ago may incur penalties even when no ATED is due.
In summary, SDLT implications for transferring properties to a company are significant, and Property118's strategy to claim partnership relief is a contentious one, likely to succeed in rare cases. Late filing of SDLT or ATED Returns can lead to penalties, adding to potential tax costs and compliance burdens.
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Legal and Tax Analysis - Taxation of Interest Payments and Indemnity Payments
1. Interest Payments and Indemnity Payments
- The Property118 scheme involves a complex arrangement related to interest payments on mortgages and indemnity payments made by the company to the individual (X), who holds the legal title to the properties.
2. Nature of the Legal Ownership
- In the scheme, X retains legal ownership of the properties but is considered a nominee or agent for the beneficiary company.
- It is claimed that X continues to make mortgage payments as the nominee and claims these payments back as tax-free out-of-pocket expenses.
3. Misconception Regarding Nominee/Agent Role
- It is important to clarify that X, as the legal owner, is not acting as the "agent" or "nominee" of the company under the loan.
- X remains the borrower under the mortgage in their own right, and the company is making indemnity payments to X, which X uses to pay the mortgage lender.
- This means that X remains liable for taxation.
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4. Loan Relationship Rules and Deductibility
- The Corporation Tax treatment of debt, including interest payments, is governed by the Loan Relationship Rules in Part 5 of the Corporation Tax Act 2009.
- For these rules to apply, the company must have a "loan relationship," which involves standing in the position of a debtor under a money debt arising from a lending transaction.
- Since the company did not borrow any money and is making indemnity payments rather than interest payments, it may not meet the criteria for loan relationships.
- The deduction of indemnity payments under general corporation tax principles for a UK property business is also not straightforward.
5. Taxability of Indemnity Payments to X
- X receives tax-free out-of-pocket expenses, which is not accurate.
- X's payments to the lender are not considered trust expenses but are personal expenses.
- Any agreement X signs with the company cannot change this fundamental tax treatment.
6. Potential Tax Consequences for X
- X may face significant tax consequences due to the indemnity payments received from the company.
- If these payments are considered income, they could be taxable, resulting in a tax charge for X.
7. Counter-Argument
- One potential counter-argument could be that the indemnity payments form part of the consideration for the original sale.
- If the original sale was exempt from Capital Gains Tax (CGT), this argument might not result in additional tax for X, but it would mean that the company would not get a tax deduction for the indemnity payments.
8. Best- and Worst-Case Scenarios:
- The tax outcomes in various scenarios range from potentially more than doubling X's original tax bill to a best-case outcome that is still worse than the original tax liability.
- The specifics depend on whether the payments are considered income or capital.
9. Communication with HMRC
- It is crucial to properly disclose these arrangements to HMRC, as the issue may not have been addressed in the past.
- Any discrepancies in tax treatment could lead to legal issues and penalties.
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Legal and Tax Analysis - Inheritance Tax and Share Valuation
1. Inheritance Tax Projection Concerns
- Cotswold Barristers have presented clients with Inheritance Tax(IHT) projections that appear unrealistically large and speculative.
- These projections may involve potential inheritance tax liabilities based on extremely optimistic assumptions, which could be misleading or result in misrepresentation.
2. Advantages of the Smart Company Solution
- The Smart Company solution suggests creating different classes of shares with varying dividend rights, allowing for tax planning.
- Shares with nominal initial values but significant capital appreciation are mentioned as a way to reduce inheritance tax (IHT) exposure.
3. Valuation of Shares
- The strategy involves issuing shares with a nominal value (e.g., £0) today, with the expectation that their value will appreciate significantly over time.
- However, there is a question of whether these shares truly have a value of £0 when created, which is central to the tax implications.
- The shares' current value is typically calculated as the discounted expected capital appreciation, which may result in immediate IHT and capital gains tax consequences.
4. Litigation History
- There have been cases where shares with similar characteristics have been litigated, and claims that the shares were valueless have failed.
- This suggests that tax authorities may challenge the assertion that these shares have no value when created.
5. Use of Discretionary Trusts
- Cotswold Barristers and Property118 have advised placing these shares in Discretionary Trusts to shelter future capital growth from IHT.
- However, it is crucial to ensure that such trusts are not simply a sham or a mechanism to retain control while avoiding tax.
6. Tax Rules for Dividends and Children
- The strategy of creating shares for children to receive dividends and pay less tax may be subject to specific tax rules.
- There could be restrictions or limitations on this approach that need to be carefully considered.
7. Compliance and Transparency
- Clients should be cautious about overly optimistic inheritance tax projections and consider the potential tax consequences of the strategies proposed.
- Ensuring compliance with tax laws and regulations and providing accurate information to tax authorities is essential to avoid potential legal issues or penalties.
In summary, concerns have been raised about the realism and accuracy of inheritance tax projections and strategies involving share valuation and discretionary trusts. Clients should seek professional tax advice to fully understand the implications of such arrangements and ensure they are compliant with tax laws and regulations.
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Conclusion
Given the complexity and potential risks associated with these tax and property arrangements, the importance of seeking professional advice and ensuring compliance with tax laws and regulations is emphasised. Additionally, clients are advised to critically evaluate the tax projections presented and be cautious about unrealistic assumptions.
In conclusion, the Property118 strategy for buy-to-let landlords involves complex legal and tax arrangements, and the concerns raised by Tax Policy Associates (Dan Neidle) highlight potential risks and challenges associated with this approach.
Clients considering such strategies should exercise caution, seek expert advice, and ensure full compliance with tax laws to mitigate potential legal and financial consequences.
