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There are many reasons why residential property investors are now rushing to incorporate, the biggest reason being the Restriction of Mortgage Interest Tax Relief.
Clause 24 of the Finance Bill sets out plans is to restrict individuals on claiming mortgage interest as a cost against their property investment income, for individuals it will work as follows
2017/18 75% of the interest can be claimed in full and 25% will get relief at 20%
2018/19 50% of the interest can be claimed in full and 50% will get relief at 20%
2019/20 25% of the interest can be claimed in full and 75% will get relief at 20%
2020/21 100% will get only 20% relief
For a 20% tax payer that’s fine but for higher rate taxpayer its a disaster that will lead to them paying a lot more tax
These rules will not apply to Companies, Companies will continue to claim full relief.
When you sell or give a residential property to your Company you will incur Capital Gains Tax if you make a gain, its for this reason many investors and their advisers believe that they are ‘automatically’ entitled to claim Incorporation Tax Relief, but in many cases Incorporation Tax Relief will NOT be available!
In summary Incorporation Tax Relief allows Sole Traders to postpone/hold over a gain by transferring all their business assets into a limited company in return for Shares.
The key problem area is the Property Investment is generally not considered to be a Trade.
Some of the issues were resolved in EM Ramsay v HMRC  UKUT 0226 (TCC)
Mrs Ramsey carried out the following activities
- Mr & Mrs Ramsey personally met potential tenants
- Mrs Ramsey check the quarterly electric bills
- Mrs Ramsey arranged insurance
- Mrs Ramsey arranged and attended to maintenance issues (drains)
- Mrs Ramsey and her son maintained the garages and cleared rubbish
- Mrs Ramsey dealt with post
- Mrs Ramsey dealt with fire regulation issues
- Mrs Ramsey arranged for a fence to be erected
- Mrs Ramsey created a flower bed
- Shrubs were pruned and leaves swept
- The parking area was cleared of weeds
- The flag stones were bleached
- Communal areas were vacuumed
- Security checks were carried out
- She took rubbish to tip
- She cleaned vacant flats
- she helped elderly tenants with utilities
This work equated to at least 20 hours per week and Mrs Ramsey had no other employment.
It is because she did the work herself that her property investment was considered a ‘Business’ and eligible for Incorporation Tax Relief. In summing up the Judge said…
If Mrs Ramsay had employed a Property Management Company or Letting Agent to do the work she would NOT have been able to claim ‘Incorporation Tax Relief’.
Most Buy to Let Landlords with one or two properties are Passive Investors who delegate all the responsibilities to professional letting agents, they will not be doing enough to comprise a business!
Lets start with a typical scenario:
- Mr Smith has been running a small garage for a few years
- he decides to incorporate his business and sets up Smiths Garage Limited with himself as the sole director and shareholder
- he transfers the goodwill of the business and its other assets and liabilities to Smiths Garage Limited but does not claim incorporation tax relief under Taxation of Chargeable Gains Act (TCGA) 1992, s162, nor does he claim hold-over relief under TCGA s162
- at the time of incorporation, the goodwill of the business is valued at £100,000
- Mr Smith makes a chargeable gain on the transfer of the goodwill, which is deemed to be at market value, of £100,000 which, after deducting the annual CGT exemption (£10,900 2013-14), will be taxable at 10% due to the availability of entrepreneur’s relief
- the company will pay Mr Smith £100,000 for the acquisition of goodwill and this is done by way of a credit to Mr Smiths director’s loan account. Mr Smith is able to draw down on this account without any further tax charges.
In addition Mr Smith started his Sole Trader business after the 1st April 2002 so he can claim a corporation tax deduction for amortisation of the goodwill in the company accounts. Small Companies pay Corporation Tax at 20%, so being able to deduct Goodwill on £100,000 will save £20,000 in Corporation Tax.
However, please bear the following in mind:
- If the business started before 1st April 2002, Corporation Tax Act 2009 s895 prevents the company from claiming a deduction against corporation tax, also refer to HMRC Spotlight 1: Goodwill – companies acquiring businesses carried on prior to 1 April 2002 by a related party
- Where a trader transfers his business to a limited company of which he is a ‘substantial shareholder’, the parties are treated as ‘related parties’ and the transfer must be at market value, but you can ask HMRC to carryout a post transaction valuation check by submitting form CG34
- Goodwill relating to personal services is not normally considered to have a market value as it can not be transferred
- In general it is expected that intangibles will have a useful life of no more than 20 years
- Get professional advice to help you to prepare the valuation, disclose the capital gain and claim the tax relief
This is a question I am asked often, normally in casual conversation at social gatherings, and one of the reasons I try not to let people know that I’m an accountant; I can only imagine how much worse it must be for doctors …..
Without knowing precise details of a business operation, it is difficult to respond to such questions with any great certainty, but there are some ‘rules of thumb’ we can employ to which might lead us to a reasonable conclusion.
But first, it might be worth taking a brief look at what options exist and what the main features of each are, and in doing so I am deliberately excluding Public Limited Companies (“plc”) which is the legal form of a majority of large businesses which shares are traded on various stock exchanges.
Private Limited Liability Company (“Limited”)
A limited company is formed, or ‘incorporated’, by an individual or group of individuals wishing to carry out a particular business. Most importantly, once incorporated, the company is a separate legal ‘person’ from its owner(s); it exists in its own right, pays its own taxes, can sue or be sued, and so on.
A Memorandum of Association is drawn up which states why the company has been incorporated and what business it is allowed to undertake, and Articles of Association set out the basic rules by which the company should be run, such as what happens when one of the owners wishes to sell their share of the company.
The owner(s), often referred to as ‘members’, will each own a share of the company (hence the alternative term ‘shareholder’), their liabilities for the debts of the company are generally limited to whatever they have paid for that share of the company, and their personal assets are therefore protected from attack by creditors of the company.
The owner(s) will appoint one or more ‘directors’ to run the company for them (i.e. to ‘act for the company’ so that it effectively operates through them). The directors may be paid a fee and/ or expenses for attending meetings and generally acting for the company.
In turn the director(s) may employ staff to work within the company and may themselves work within the company, and this is often referred to as an ‘executive’ directorship, as distinct from a ‘non-executive’ directorship where the director may attend board meetings only and vote on various issues concerning the running of the company.
In law, executive and non-executive directors are all simply directors and have the same authority and responsibilities for the running of the company, but executive directors will have additional authority and responsibilities in terms of running the business of the company as set out in their service contract or contract of employment, and for which they will normally be paid a wage or salary.
So an individual may be a shareholder, and/ or a director, and/ or an employee (executive) of the company, but they are three very distinct roles and whenever an individual acts ‘on behalf’ of the company, or the company’s business, he or she needs to be clear which ‘hat’ they are wearing so that these roles do not become confused.
This distinction is particularly important when considering payments made between the company, its director(s), its owner(s), and its employee(s) so for clarity:
The company itself (not the owners), is liable for ‘Corporation Tax’ on the profits it makes and currently there is a Small Companies Rate of 20% on profits of up to £300,000 in a year, and thereafter a Main rate of Corporation Tax of 23%, but these change periodically so please check the current rates at http://www.hmrc.gov.uk/rates/corp.htm.
The company pays its employee(s) for the work they do and such payments are legitimate business costs and can be set against profits thereby reducing any corporation tax due; conversely these payments are income for the employee(s) on which they will need to pay tax and other deductions (the company is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).
Any profits made by the company, after corporation tax has been paid, can be shared out between the owner(s), normally pro-rata to their shareholding, and this is termed a ‘dividend’ payment, and because corporation tax has already been paid in respect of these profits, the dividend carries a tax credit (currently 10%) which the owner(s) can effectively claim back as tax already paid against any other tax they may need to pay.
Tax on such dividend income is at a lower rate to normal earned income (I don’t know why but have always presumed in recognition of the risk the owner(s) have taken in investing in their company), and so currently if the owner is a basic rate taxpayer, the tax credit fully offsets the tax due on the dividend income, and so there is no further tax to pay on it; again these rates change from time-to-time so please check the current rates at http://www.hmrc.gov.uk/rates/it.htm.
One particular downside of tax regime as applied to limited companies to be aware of is that where the company provides a car for its employees, whether executive directors or other staff, this is deemed to be in lieu of wages or salary, and regardless of whether the car is a necessary tool of the trade as it is for many small business owner/ directors, or individuals with for example sales roles. And depending upon the cost of the particular car and whether the company also provides fuel, the tax assessment can be quite harsh – see http://www.hmrc.gov.uk/calcs/cars.htm. This tax regime also applies to commercial vehicles provided by the company though the tax assessment is currently less harsh.
Finally, a company is required to disclose details of its operation including a ‘filing’ of its annual accounts at Companies House where other individuals and organisations can view these. For many small businesses this will be an abbreviated version of what is prepared and submitted to HM Revenue and Customs being limited to an end of year balance sheet only, rather than the full profit and loss account required by HMRC.
When an individual ‘starts up in business for themselves’ then they are termed a ‘sole trader’, and unlike the limited company, which is a separate legal entity from its owner(s), the sole trader and his or her business are one and the same.
The most important consequence of this is that generally, all the personal assets of the sole trader are at risk from attack by creditors should the business fail or find itself in difficulty.
The main advantages of this trading form is its simplicity and the lack of disclosure of the businesses financial affairs at Companies House (there is little real saving in record keeping or accounts preparation since the accounts to be prepared each year for HMRC are little different to those required for a limited company).
The sole trader is liable for tax and national insurance on the profits made by their business and any salary or wage which they take out of the business is not allowable against these profits in calculation the tax and NI due.
Conversely such payments, which are termed ‘drawings’, are essentially a distribution of the profits made and are not assessable for tax since they have already been taxed originally as profits. Note that monies introduced into the business by the sole trader are termed ‘capital introduced’, profits made add to this capital, and drawings (including tax paid) taken reduce it, so if the business is not making profits then any drawings simply deplete the capital (and cash reserves) of the business
Further, there is no saving in payroll administration once the sole trader takes on staff since as with a company the sole trader pays its employee(s) for the work they do and whilst such payments are legitimate business costs thereby reducing any tax due from the owner in respect of his/ her business profits, these payments are of course, income for the employee(s) on which they will need to pay tax and other deductions (the sole trader is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).
Equally, whereas the sole trader can generally charge the business proportion of all running costs of a vehicle to profits, thus reducing their tax bill, any vehicle provided to employees fall under the same regulations as those for company employees.
The sole trader will generally have to make advance payments of tax, essentially a deposit or ‘on account’ payment on the current year’s anticipated profits, and which will be estimated based on the previous year’s profit, so there is a real danger in a poor trading year of substantially overpaying tax when cashflow can least afford it, albeit the overpayment can be refunded once the true trading position becomes clear.
Finally, consideration should be given to timing when starting up the business in relation to the tax year since HMRC will assess profits made by ‘basis period’ – see http://www.hmrc.gov.uk/manuals/bimmanual/BIM71010.htm which may mean that any profit may be the basis for assessment of tax in more than one tax year.
There are several types of partnership but generally what is referred to when speaking of ‘a partnership’ is a Partnership within the meaning of the Partnership Act 1890 – see http://www.legislation.gov.uk/ukpga/Vict/53-54/39/contents
Such partnerships are formed by two or more individuals wishing to carry out a particular business, and they may or may not formally write down any rules and regulations for running the partnership such as who will receive what share of any profits.
If such partnerships are thought of as a ‘group of sole traders’, then much of what is set out in the above section can be said to apply equally here. However there are two variations on this basic theme:
Limited Partnership regulated by the Limited Partnership Act 1907 see – http://www.legislation.gov.uk/ukpga/Edw7/7/24/contents – in which at least one of the partners restricts their liability for the debts and obligations of the firm to a pre-determined sum, instead of bearing unlimited liability as a partner normally does.
The partnership must consist of at least one general partner who manages the business and bears unlimited liability to creditors, and at least one limited partner (who may not take part in the management of the firm’s business). The limited partner must contribute a specified amount of capital on joining the firm, which they cannot withdraw as long as they remain a limited partner, but cannot be made to bear any liability to creditors or their fellow partner(s) in excess of that amount plus any undrawn profits.
A limited partnership must register with the Registrar of Limited Partnerships in London or Edinburgh as appropriate and failure to register deprives it of its limited liability status.
Limited Liability Partnership (“LLP”) – governed by the Limited Liability Partnership Act 2000 – see http://www.legislation.gov.uk/ukpga/2000/12/contents – an alternative corporate business vehicle that gives the benefits of limited liability but allows its members the flexibility of organising their internal structure as a traditional partnership.
It is a separate legal entity and, while the LLP itself will be liable for the full extent of its assets, the liability of the partners will be limited.
Any new or existing firm of two or more persons can incorporate as an LLP, which must be registered at Companies House and for which the registration process and cost of registration are similar to that for a limited company.
Disclosure requirements are also similar to those of a company since LLPs are required to provide financial information equivalent to that of companies, including the filing of annual accounts, an annual return, and notification of any changes to the LLP’s membership, members names & residential addresses, and change to their Registered Office Address.
However, a LLP is taxed as a partnership, the partners providing capital and sharing any profits (the LLP will normally be regarded as transparent for tax purposes and each member will be assessed to tax on their share of the LLP’s income or gains as if they were partners of a general partnership governed by the Partnership Act 1890; partners will be liable to pay Class 2 and Class 4 NIC.
The trading form of the business, as we can see from the above, can take a variety of forms, and in answer to the question originally posed it is useful to consider the response to the following points:
1. if the business is relatively simple with little by way of borrowings from banks and other lenders, or credit to customers, or from suppliers, then a simple sole trader (or partnership for more than one individual) may be most appropriate;
2. where protection of personal assets and therefore limited liability is an important consideration then incorporation as a private limited liability company (or change to LLP status for an existing partnership) should be seriously considered (but be aware that this will still not protect the owner/ director if personal guarantees have been given to lenders in lieu of security for their loan);
3. if the business runs expensive motor cars then there could be a significant additional tax liability arising on incorporation of the business which might outweigh other advantages (if limited liability is desired then it may be worthwhile considering removing the vehicles from the business and running as privately owned vehicles, and charging the company per mile for use on company business post incorporation);
4. there is some flexibility on when and how much tax is paid overall for a limited liability company, for example, profits and therefore cash could be retained in the company, say for investment, and distributed subsequently as dividends when cashflow permits (as a sole trader or partnership there is less flexibility in that tax is due on profits irrespective of whether cashflow has permitted the profits to have been taken as drawings) so if such flexibility is important then again incorporation should be considered;
5. save for at business start up, tax is normally paid earlier by sole traders and partners, so there may be cashflow advantages in incorporating once the business has been established.
The above is of course, a very generalised assessment and having given due consideration to these generalities, I would advise that you then talk over the particular requirements of your particular business with your accountant and/ or business adviser before making a final decision.
As ever in life, few alternatives are ‘all good’ or ‘all bad’, and you will need to weight up the pros and cons as they apply to your particular circumstances and settle on the best overall option for you.
Paul Driscoll is a Chartered Management Accountant, a director of Central Accounting Limited, Cura Business Consulting Limited, Hudman Limited, and AJ Tensile Fabrications Limited, and is a board level adviser to a variety of other businesses.