Alan Pink considers the tax implications of transferring shares and land, and highlights a pitfall with ‘clever’ planning.
There are obviously a number of motives behind people transferring interests in property, or property holding company shares, to other people; but I’m going to be concentrating here on gifts (or ‘sales’ at a significant undervalue), which are made with a view either to reducing the transferors’ inheritance tax (IHT) liability, or to benefiting the recipients. And indeed, it’s here that the tax implications become a little bit thorny on occasions.
Trading or Investing?
The crucial question to ask before anything else is whether your interest in the property business is of a ‘trading’ or ‘investment’ nature. The reason this is so crucial is that the tax treatment of the two separate activities is radically different. So let’s have a look, first of all, at how you distinguish between the two.
With the exception of furnished holiday lettings (which have their own separate rules), holding a property long term for rent is an investment activity, not a trading activity. In order to qualify as a trading activity (which, from the point of view of transfers, is a more favoured status), you need to show that you’re holding property with a view to selling it at a profit.
There’s no single criterion used to decide which side of the line a given activity falls, but ultimately the question is one of intention; are you holding the property concerned (or is the company holding it) with a view to selling in the foreseeable term at a profit, or does the motive of finding somewhere to hold value predominate? So you look at the following factors to decide:
- The frequency with which you buy and sell properties;
- The length of time over which properties are held;
- The type of finance, if any. So, for example, a long-term loan is an indicator of investment activity;
- Improvement work on the property;
- Advertising the property for sale;
- The existence of business plans, correspondence, and any other evidence suggesting an intention to hold long term or, by contrast, sell at a profit.
Making a gift of a property that is held by way of a trading business is comparatively straightforward from a tax point of view. Although any transfer of a capital asset, such as shares in a company, is prima facie chargeable to capital gains tax (CGT) based on a deemed market value sale of that asset, if the asset concerned is the shares in a ‘trading company’, the gain can be ‘held over’ and effectively deducted from the transferee’s base cost carried forward.
On the other hand, if what you are looking at is an investment company, the gain can’t be held over on a transfer to another individual.
The use of ‘funny’ shares
So the incidence of CGT on transferring any interest in an investment property business is the clear enemy of the wish to benefit the younger generation, and, in particular, to save IHT. You could say that you are caught between the devil and the deep blue sea.
One way in which some planners seek to circumvent the rules is by the issue of shares in a company with different rights. As with any kind of complex tax planning, there’s a right way and a wrong way to do it.
The following is an example of a wrong way of doing it, which highlights a particular part of the CGT code that is often overlooked.
Example 1: ‘Funny shares and value shifting
Tried and Tested Limited is a property investment company, which has properties with a net value of £1 million. Accordingly, the shares in the company as a whole, of course, also have that value. When the story begins, father owns 100% of the shares in the company, which originally cost him a nominal sum because the property portfolio within the company has been built up in value by him ever since. He wants to transfer shares in the company to his son in order to save IHT but has run against the problem of a gift of such shares triggering a CGT liability. So he answers an email shot from Mushroom Tax Solutions Limited, who claim to have the answer to this tax problem – and indeed many others.
Acting under their instructions, father passes resolutions of the company to issue a small number of new shares to his son. In terms of nominal value, these shares are less than half a percent of the total issued share capital of the company, and only give rights to a corresponding proportion of the company’s assets. It is all calculated in such a way as to avoid father transferring any value over to his son as calculated under the current situation.
But these shares have unusual rights. First of all, they are entitled to enjoy the benefit of all the rents received, starting from now. Secondly, they are entitled to receive the benefit of any increase in the value of the company’s properties from now. The idea is that, whilst at the current time the shares issued to his son have a negligible value, they will gradually increase in value at the expense of father’s ordinary shareholding as the years pass.
The HMRC officer who investigates the situation believes otherwise. He feels that the shares owned by son have effectively formed part of a ‘value shifting’ exercise by father, and the transfer of value is a significant one because of the rights that the new shares have over all future income and capital gains of the company. Under special ‘value shifting’ rules (in TCGA 1992), this is treated as a disposal by father to son, and CGT becomes payable.
The above isn’t intended to be a blanket condemnation of all ‘funny share’ arrangements, but just a cautionary tale to alert planners to the very real dangers posed by the value shifting rules. Those rules state, in summary, that where any person who controls a company exercises that control in such a way as to cause value to pass out of the shares he owns, into other shares in the company, that is treated as a disposal. Valuation questions, particularly in the kind of situation outlined in the example above, can be truly horrendous to sort out.
Other solutions
As an alternative to using ‘funny’ shares, you could consider making transfers of the shares into a trust. Subject to the IHT ‘lifetime charge’, if you make transfers into trust of no more than £325,000 over a cumulative seven-year period, this idea is worth considering because a transfer into trust, even of an investment business, qualifies for CGT holdover relief. The £325,000 effective maximum, before 20% IHT becomes payable on the lifetime transfer, is a very severe restriction, although sometimes it is possible to juggle IHT and CGT, so to speak, by making a sale to the trust at an undervalue. It is only the undervalue that is potentially chargeable to IHT, and if the value is low enough it may trigger little or no CGT after the holdover relief claim.
Another solution, or partial solution, to this tension between CGT and IHT exists where the business is in the form of a limited company rather than an unincorporated property portfolio. A minority interest in a company is generally valued quite low for CGT purposes but can have a disproportionate effect on the IHT position. Let’s have a look at another example.
Example 2: Losing control
Grandpa has 51% of the family investment company, which has a gross value of £1 million. He gives 2% to his grandson, thereby significantly reducing the value of his estate because he now only has 49% of the company.
Whereas a 51% holding would probably be valued without any discount (i.e. at £510,000), a 49% holding might well be worth not much more than half this, if a substantial discount applied.
So much for IHT. For CGT purposes, by contrast, you would look at the 2% holding in isolation, and this might well have a fairly negligible value because it is such an uninfluential minority – perhaps as low as £10,000. Hence CGT can be controlled whilst obtaining meaningful reductions in the potential IHT charge.
You could even consider getting down to this position slowly, by a series of transfers of small interests. However, you should bear in mind the CGT rules relating to ‘assets disposed of in a series of transactions’, where the market value of the combined transfers is used if there is less than six years between each one.
