When Does Incorporation Stack Up for Landlords? Part 2

This is the second in a series of articles on key issues that residential property landlords should consider when looking at whether or not to incorporate their property business. In the first article, we looked at why there may be a net ongoing benefit to incorporation for some landlords, specifically those facing substantially increased finance costs thanks to the new income tax regime.

In this article, we shall look at one of the main impediments to simple incorporation relief for capital gains tax (CGT) purposes – one of the main routes to incorporating a pre-existing buy-to-let (BLT) business (note – we are looking only at capital gains here: the stamp duty land tax (or land and buildings transaction tax in Scotland) and other implications of incorporation are outside the scope of this article).

What is incorporation relief and why is it useful?

Many landlords will have held property for years – decades, even. Such portfolios tend to have increased very significantly in value – they may now be worth (say) two or three times what the landlord originally paid for them. Landlords in this position will, of course, be aware that those properties will be exposed to CGT if and when they are sold. But many landlords do not realise that this CGT will by default apply even if the property is given away.

Example 1: ‘Gift’ of properties to company

Bill has four properties that he bought twenty years ago for £200,000; they are now worth £550,000. He knows that if he sells the properties on the open market then he will make a gain of £350,000, so long as he achieves the full asking price.

Bill wants to incorporate his BTL business, to avoid the increased income tax charge. He knows that he could sell his properties to his company, so that the company owes him £550,000. He understands that he will have made a capital gain of £350,000, even though he is selling to his own company.

So, Bill decides to give the properties to his company instead. Unfortunately for Bill, tax law basically says HMRC is entitled to its slice of CGT even if Bill doesn’t take any money: this is not a bad bargain but a deliberate arrangement by Bill to transfer at undervalue. The transaction is taxable as if Bill had sold at the full market value of £550,000 – Bill will have to pay tax on a capital gain of £350,000, even though he has not received any money (see, for example, HMRC’s Capital Gains manual at CG14530 et seq).

Incorporation relief route

Example 2: Incorporation relief

Ben also has four properties standing at a capital gain of £350,000. Unlike Bill, he is fully aware that a gift can be ‘caught’ for CGT, so he opts for the incorporation relief route. He sets up a company and arranges for the company to exchange shares in itself for Ben’s portfolio.

In effect, Ben’s bricks and mortar property wealth is transmuted into paper – his shares in his new company. The company has offered no money or consideration other than shares in itself. Ben therefore claims incorporation relief (under TCGA 1992, s 162), so that his capital gain is now held over into the company shares – there is no capital gain now, but disposing of a fraction of the shares at some later stage will effectively trigger a corresponding fraction of the postponed capital gain (let us suppose that Ben is happy with this, since he intends to hold on to those shares for the long term).

Many readers will be aware that property businesses are not guaranteed to qualify for incorporation relief but should do so where their circumstances are sufficiently similar to those in the case of Ramsay v HMRC [2013] UKUT 0226 (TCC) (see HMRC’s Capital Gains manual at CG65715, but note that this is HMRC’s interpretation of the case); Ben’s lettings portfolio qualifies as an active ‘business’ in the context of incorporation relief, so Ben looks forwards to a CGT-free future, presumably with the odd Daiquiri and/or Gin Sling for good measure. Or does he?

Mechanics – transferring liabilities

The key issue that has not yet been addressed is business liabilities – mortgages, etc. Many landlords will assume that the business liabilities follow the business, and that is commonly the case. But there are implications. HMRC allows that the business’ liabilities do not ‘count’ as consideration when transferred to the company, so incorporation relief is not restricted.

Example 3: Liabilities transferred but no relief restriction

Benjamin has four properties that he bought in 1997 for £200,000, with a £100,000 mortgage. The properties are now worth £550,000, and the mortgage is now £75,000. He has incurred no enhancement expenditure on the properties, so the only deductible amounts for CGT purposes are the original costs of acquisition and any incidental costs to dispose of the assets, etc. (which we shall treat as negligible, for convenience).

Benjamin transfers his four properties into his new company, in exchange for shares and no other consideration. The company also takes on the borrowings. Assuming his BTL portfolio satisfies the relevant criteria to be considered eligible for incorporation relief, the calculation is:

Benjamin’s gain is £550,000 - £200,000 = £350,000

The property portfolio is worth £550,000 - £75,000 = £475,000

The CGT cost of the shares in this simple example is their market value, less the gain now postponed: £475,000 - £350,000 = £125,000 (i.e. Benjamin’s own base cost, net of finance)

The gain is held over in full. Benjamin will have a relatively low base cost to his shares as and when he comes to sell or otherwise dispose of them, but he has avoided any CGT now, on incorporation.

However, the amount of the gain that can be held over under incorporation relief is restricted where the gain exceeds the net value of the assets transferred.

Example 4: Liabilities transferred but relief restriction arises

Benito also has four properties that cost him £200,000 and are now worth £550,000. The gain is therefore £350,000, as before (again, ignoring any incidental costs and assuming there was no enhancement expenditure).

However, Benito has bought his properties over a period of several years, starting roughly 15 years ago, and borrowing heavily against his ‘earlier’ properties to finance the later additions. His borrowings now stand at £250,000 – more than the aggregate original cost of the properties, but still comfortably less than their current value. Benito does, of course, want to transfer his borrowings to the new company – that is the whole point of the incorporation exercise.

Benito’s gain is £550,000 - £200,000 = £350,000

The property portfolio is worth £550,000 - £250,000 = £300,000

The CGT cost of the shares on the transfer is their market value less the gain now postponed:

£300,000 - £300,000 (restricted) = £Nil, leaving £50,000 of gain that cannot be postponed through incorporation relief, and that would be assessable on Benito immediately.

Conclusion

Incorporation relief, like many things in the world of tax, is deceptively simple. It is essential to model any proposed transaction thoroughly, to make sure that the relief works as intended – and that there are no unexpected pitfalls. Despite the residual capital gain, Benito would still stand to postpone CGT on £300,000 of gain, so the exercise might still be worth his while.