A ‘Pea-Souper’ Of A Question

Alan Pink considers a vexed property question for rental property landlords on which there is probably too much advice at the moment, and offers some of his own!

We’re all familiar, from the books and from numerous films, with the picture of Sherlock Holmes and Dr Watson groping their way through a thick London fog after dark, trying to track down the answer to a puzzling conundrum. Landlords of properties are going through a similar experience, metaphorically speaking, just at the present moment. This isn’t exactly a new problem, but it’s one that has become much more acute recently. 

The question, which is obscured by the swirling fogs of ill-informed and contradictory advice, is the basic and very topical one of how you should structure your property portfolio investment for maximum tax efficiency. This was always an important question because of the existence of higher rates of income tax going up to 45% currently, with, by contrast, very much lower rates of corporation tax applying to the income of companies. But it has become much more acute, as we all know, by the introduction of the ‘Osborne tax’, which is just now beginning to bite much harder and will very soon be giving rise to cruelly anomalous results.

For those readers who are new to the tax game, the imposition we refer to as the ‘Osborne tax’ is the partial disallowance of interest on loans taken out to acquire buy-to-let properties. Currently, only 50% of this interest is allowable, effectively, as a deduction for higher rate (40% and more) income tax purposes: and next year this will go down to 25%, with higher rate relief disappearing completely in the years after that. So, those who have borrowed a lot of money to acquire their portfolio can end up paying a very much higher effective rate of tax – in some cases, even exceeding 100%. 

Barring very obscure ‘solutions’ to the problem of higher rate tax, a landlord basically has three options: 

Hybrid structures are basically structures where both individuals and limited companies are sharing the ownership of the property portfolio. The form of this hybrid ownership which is most often found is a limited liability partnership (LLP) that owns the properties, and in which both the individuals and limited companies that they control are members. A partnership or LLP agreement will set out exactly what the rights of each of the members to income and capital gains are. So, profits can be attributed to the company member, subject to constraints, and there enjoy the same advantage as income in a limited company owned property portfolio; that is, the lower rates of tax on the income.

The advantages of hybrid structures are, unfortunately, very little understood by advisers as a whole, including a lot of people who are jumping on the bandwagon of advising landlords on tax structuring. This is the main reason, in my view, for the thick fog which surrounds the whole subject. 

What I’ll try to do here is set out concisely the pros and cons of the limited company structure on the one hand and the hybrid structure on the other. I’ll pass quickly over the ‘do nothing’ option, as its advantages and disadvantages are fairly obvious.

So, why would you want to acquire your portfolio in a limited company, or transfer a current portfolio into the ownership of a limited company? Obviously, the effect of doing so would be that the rental profits will be chargeable at corporation tax rates, which are currently 19% and hopefully will come down to 17% shortly. This contrasts with effective income tax rates of up to 45% or, with the Osborne tax, potentially considerably more. A limited company is a relatively simple (conceptually) and non-controversial way of bringing about this effect, and there are unlikely to be any unforeseen pitfalls in the way the taxation of the company works out on an ongoing basis. These are substantial advantages and shouldn’t be underestimated. 

On the other hand, you have the tricky issue of tax on transferring pre-owned properties into the company. First of all, there is the spectre of capital gains tax (CGT). This may be avoidable if you use ‘incorporation relief’, under which shares in the company are issued to you in return for your portfolio. This can avoid capital gains tax on the very important proviso that HMRC agree that your property portfolio holding is a ‘business’. If they don’t agree, there is the possibility of a huge CGT charge based on the market value of your portfolio. 

Secondly, there is the stamp duty land tax (SDLT) charge (separate regimes apply in Scotland and Wales). With SDLT now at very high rates, including as high as 15%, this could be a huge tax charge resulting purely from you re-arranging the way your portfolio is held. Many advisers accept that this SDLT is unavoidable. Others suggest putting your portfolio into an LLP for a set period and then transferring it from the LLP to the company – making use of a special relief from SDLT which applies in these circumstances. Unfortunately, in my view, there is more than a hint of the ‘preordained’ about these suggestions, and you could easily end up with a big unexpected SDLT charge if HMRC investigated and decided to take this ‘preordained’ point. 

Both of the above are potentially formidable objections, and at best are a significant risk. But in my view, an even more worrying effect of putting your property portfolio into a limited company is that you are storing up a potential ‘double tax charge’ on any future sale of the properties. This first layer of this tax charge would apply on the sale of the property by the company, and the second on passing the proceeds out to you personally. Depending on circumstances, this could result in a very large increase in the effective tax rate on capital gains. Moreover, once properties are ‘trapped’ in a company, you don’t have the advantage of the CGT-free uplift to property on the death of the owner and the bequest of the properties to the next generation.

But the absolute killer might be that, when you draw income from the company, this will, in any event, become chargeable at whatever your marginal rate of income tax is. Some advisers have come up with an ingenious scheme under which you can both avoid CGT on transferring the portfolio into the company in exchange for shares, and retain an amount owed to you (by the company, after the incorporation) on which you can draw down tax-free. However, my own feeling is that these arrangements may be provocative and produce a result which is deemed ‘too good to be true’.

These are pretty much the converse of the company structure. That is, hybrid structures are more ‘tricksy’ and complex than company structures and could, therefore, be regarded as more controversial. However, the rules relating to the transfer of existing portfolios are much clearer cut and it is possible to bring this about relatively certainly without any CGT or SDLT liabilities. Future gains can be retained by the individuals, ensuring that there is only one layer of tax. Profits attributed to the company will bear tax at the company rate unless this attribution is ‘excessive’. Despite this, drawings up to the full current (and indeed future) equity value of the properties can potentially be made by the individuals tax-free.

The constraint on how much profit can be attributed to the company is that, in a nutshell, it can only receive profits from the LLP equal to what it has earned, either by its actual exertions on the LLP’s behalf in running the portfolio, or in terms of the capital it has invested in the LLP. In many cases this won’t be a problem in practice; however, you should look to see whether it is possible to bring about the position that the company has substantial capital invested in the LLP.

Every situation is different, of course. However, my own feeling is that hybrid structures are much less common in practice than company structures, only because they are insufficiently understood. The drawback of ‘trapping’ future capital gains in a limited company is such a great one, and so difficult to predict, that the hybrid structure will win nine times out of ten in my book.