Practical guide: Incorporating a property business
An individual with a significant property portfolio is considering incorporating their business. What are the key considerations and are there any traps to avoid or tax planning opportunities?
The individual started buying residential buy-to-let properties back in 2009 following the financial crisis, and now owns a total of ten properties. They cost £800,000 and have a current market value of £1.5 million. Mortgages are on an interest-only basis and total £950,000. The individual is employed as an IT consultant and is a higher rate taxpayer. He manages the properties himself which he fits around his employment. He understands that incorporating the business would benefit him due to the lower corporate rate of tax, full interest relief on the mortgages, and greater flexibility over IHT planning by being able to gift small numbers of shares in the company in tranches. He is adamant that he won’t need to pay any capital gains tax (CGT) on the incorporation as he has read that incorporation relief will apply.
Before considering the availability of incorporation relief, it is important that the individual understands what the CGT liability will be if the relief is denied. As incorporation involves the disposal of assets to a connected party (the company), it will be deemed to take place at the market value (MV).
Example. The MV of the properties is £1.5 million and the base cost, £800,000. Ignoring the annual exemption and any capital losses that might be available, the taxable gain is £700,000. CGT at 28% would therefore be £196,000.
At this level of tax, it is extremely important that incorporation relief will apply, or any advantages will be cancelled out by the dry tax charge.
The conditions for the relief are contained at s.162 Taxation of Chargeable Gains Act 1992(TCGA) which the legislation calls rollover relief on the transfer of a business. The conditions that must be satisfied for the relief to apply are:
- there must be a transfer of a business as a going concern by an individual
- all the assets of the business, with the exception of cash, must be transferred to the company
- the consideration received for the business must include an issue of shares in the company.
Where the conditions are met the relief is automatic and does not need to be claimed, although reference to the transaction should be included in the white space of the tax return CGT pages.
When it comes to the incorporation of rental properties, the most important condition will be that there is in fact a business being transferred to the company, and not just the transfer of a collection of investment assets. This will be determined by reference to the activities that the owner undertakes.
Ramsay tribunal case
The Upper Tribunal decision in Ramsay v HMRC  established that property rental activities can constitute a business for incorporation relief purposes, where they are substantial in nature and represent a seriously pursued undertaking.
In addition, the owner must spend a reasonable amount of time on property-related activities. In Ramsay, these activities amounted to circa 20 hours a week.
The 20-hour figure was not specifically agreed by either HMRC or the tribunal judges, and is therefore only a rule of thumb. However, HMRC acknowledges in its manual at CG65715 that incorporation relief will apply if 20 hours or more are personally undertaken on activities that are indicative of a business. If the owner is confident that they undertake substantial activities on the properties and spend sufficient hours, a claim may be made - though it will probably be necessary to persuade HMRC later on.
Mechanism of relief - and a trap!
Where incorporation relief applies, the capital gain arising on the transfer is rolled over into the base cost of the company shares, so that the gain is only ever charged if the shares are disposed of. The base cost of the shares start off equal to the market value of the business assets transferred, but are then reduced by the gain rolled over.
|MV of properties||£1,500,000|
|Less MV of mortgage debt||(£950,000)|
|MV of net business assets||£550,000|
|Less gain rolled over||(£700,000)|
Where rental properties are re-mortgaged and the equity/cash taken out of the rental business (so that the mortgage debt exceeds the base cost of the properties), it will result in the gain rolled over being greater than the net assets and so trigger a negative base cost. As it is not possible to have a negative base cost, the £150,000 will be an immediate chargeable gain with £42,000 CGT arising, even though the incorporation may meet the conditions for incorporation relief.
Unless the cash previously taken out of the business (or another asset) is put back into the business before incorporation, there will be no escaping the CGT charge. Let's assume the cash previously extracted was recently used to purchase an investment property for £250,000 in the owner's wife’s name. If the property was transferred into his sole name and introduced into his rental business, the net assets of the business would increase to £800,000 with the gain being rolled over remaining at £700,000. No chargeable gain would therefore arise.
Pre-incorporation cash extraction?
A neat planning point, providing his wife does indeed transfer her property into his rental business, is the possibility of re-financing the properties pre-incorporation to create a tax-free directors’ loan account credit balance in the company. Because any cash in the rental business can be excluded from the incorporation, if he were to increase the mortgage borrowing by £100,000 (the level of base cost), he could exclude the cash from the transfer and instead introduce it into the company as a loan, drawing future profits tax free.
|MV of properties||£1,750,000|
|Less increased mortgage debt||(£1,050,000)|
|MV of net business assets||£700,000|
|Less gain rolled over||(£700,000)|
The £100,000 cash introduced could be used to repay the mortgage back down to the £950,000 it originally was, but the individual would now have a tax-free loan account to draw from, and potentially charge interest on, and still benefit from no CGT on the incorporation.
Stamp duty land tax
In addition to the CGT position for, the company will be liable to pay stamp duty land tax (SDLT), or the devolved equivalent. As with CGT, there is an MV rule if the purchaser is a company and they are connected to the seller. Additionally, any purchase by a company of residential property will incur the 3% surcharge.
With the property value of £1.75 million, the SDLT charge for the company initially looks like £176,250 which might make the incorporation unpalatable. However, there are a couple of things to remember:
- the purchase of six or more dwellings in a single transaction will result in the non-residential rates of SDLT applying
- a claim for multiple dwellings relief would reduce the SDLT down to £60,000.
If this proves to be too expensive for the individual, there is a possibility that he could form a partnership with his wife and incorporate further down the road, as there are favourable rules for SDLT where a partnership incorporates. However, there would need to be a strong commercial reasoning to doing this. If the partnership is merely formed to avoid SDLT, there are anti-avoidance rules to cancel the benefits.