One of your clients owns a successful trading company. He is looking to purchase three investment properties to let out, and wants advice on whether to use the company to do so. How could this be an effective tax shelter?

Scenario

Your client owns a very profitable printing business which he built up from scratch. He has been given the opportunity to purchase three residential properties from a landlord who is downsizing their rental portfolio. He is a higher rate taxpayer and plans to use a letting agent to manage the properties. He’s unsure whether to buy property in his own name or through his company, and he’s asked you to compare the relevant taxes involved.

The properties are valued at £150,000 each and would be funded by a mortgage. Your client’s bank has already indicated that they will lend to either the client personally or to the trading company.

Land tax

A purchase of residential property by a company will automatically be a higher rates transaction for stamp duty land tax (SDLT), and therefore the 3% surcharge will apply to the price bands.

Pro advice. However, any purchase by your client personally will also incur a 3% surcharge, as he would own more than one residential property and would not be replacing his main residence. There is therefore no difference in SDLT rates between the client purchasing personally or through the company.

As the properties are all being purchased from the same seller, the transactions will be linked for SDLT purposes. This means the consideration for all purchases need to be aggregated and SDLT will therefore be charged on the total of £450,000, resulting in an SDLT charge of £26,000.

Pro advice. Help is at hand though, as a claim for multiple dwellings relief can be made due to more than one residential property being purchased. SDLT will then revert to being charged on the average property price of £150,000, with a total SDLT charge of £15,000. The relief was discussed in yr. 5, iss. 2, pg. 8 (see Follow up ).

Example. A total purchase price of £450,000 for three properties = £150,000 average purchase price. Instead of the first £125,000 being taxed at 0%, and the balance of £25,000 being taxed at 2%, the price bands will be 3% and 5% respectively due to the surcharge. The result being an SDLT charge per property of £5,000, or £15,000 in total for the three properties.

Direct tax

The rental income generated from the properties will be subject to 40% income tax in the hands of your client. Tax relief will be available for the letting agent’s fees and mortgage interest.

Pro advice 1. As a higher rate taxpayer, only 25% of the mortgage interest can receive higher rate tax relief and be claimed against your client’s rental income for 2019/20. The remaining 75% will receive a maximum of basic rate tax relief only (and it can be less), via a credit off your client’s income tax liability.

Pro advice 2. From April 2020 there will be a full restriction on finance costs so that no higher rate tax relief will be available.

Rental income in the company will be subject to 19% corporation tax, with full tax relief received for the agent’s fees and mortgage interest. The corporation tax rate is set to fall to 17% from April 2020.

Pro advice. The finance cost restriction does not apply to companies, so the full mortgage interest can be deducted against rental profits.

There is therefore a clear direct tax advantage to owning the properties through your client’s trading company, both in terms of the lower tax rate on profits and the full deduction of finance costs (especially if the income tax reduction would be restricted). If your client is in need of the cash generated from the rents, the tax cost of extracting the rental income from the company will reduce the tax saving.

VAT

The letting of residential property is an exempt supply by virtue of group 1 of schedule 9 to the VAT Act 1994 . If the only supplies your client makes are exempt from VAT, they will not be eligible to register for VAT and therefore will not be able to recover any of the input tax incurred.

Pro advice. As the VAT is irrecoverable, the full VAT- inclusive costs can be set against the rental income received to help reduce taxable profits.

Your client’s company, on the other hand, will already be VAT registered due to making taxable supplies of printing services. However, the fundamental principle of VAT recovery is that input VAT is only recoverable to the extent that it has a direct and immediate link to a taxable supply. As the letting of residential property is not a taxable supply, the VAT on the agent’s fees and repairs etc. will still not be eligible for recovery. On the face of it there is no apparent VAT advantage to buying the properties personally or buying them through your client’s company. But is that really the case?

Partial exemption de minimis

Where a trader makes both taxable and exempt supplies, as would be the case for your client’s company, VAT recovery is governed under the partial exemption rules. VAT incurred on expenditure related to taxable supplies will be recoverable, and expenditure that relates to non-taxable supplies will not.

Pro advice 1. Where the VAT allocated to non-taxable supplies is de minimis, the whole of the VAT can be recovered even though it relates to non- taxable supplies.

Pro advice 2. VAT is de minimis if it does not exceed £625 per month on average and 50% of the total VAT on all expenditure per para 11.2 of VAT Notice 706 (see Follow up ).

It can therefore be beneficial to own the properties through an existing VAT-registered business and take advantage of the partial exemption de minimis rules to recover VAT where ordinarily it could not be.

Inheritance tax

Inheritance tax (IHT) is a significant source of income for HM Treasury with receipts exceeding £5 billion for the first time in 2017/18. Securing relief is more important than ever.

Pro advice. Business property relief (BPR) is available where there is a business activity which does not consist, wholly or mainly, of making or holding investments (amongst others).

The personal ownership of just one buy-to-let property would arguably not constitute a business for BPR to apply. Three properties would likely constitute a business, but in your client’s personal ownership it will be a business consisting wholly of holding investments and BPR would not apply. Would it make any difference if the properties were owned by the company?

Hybrid

As long as the rental activity is sufficient to constitute a business activity, your client’s company will have both a trading business and an investment business and will form a hybrid company as discussed in SVM111220 (see Follow up ). It will then be necessary to look at the hybrid company and determine whether the printing trading business or the property investment business predominates. Providing the trading business is the dominant one, the company will not be mainly that of holding investments and so BPR will apply.

Pro advice. If your client’s company is mainly trading, BPR will apply to the whole value of the company, including the value of the rental properties. HMRC will not treat the property investments as an excepted asset.

To determine which activity predominates, the case of Farmer v IRC [1999] SpC 216 (see Follow up ) established five criteria to consider, which broadly looks at the split of trading activities to investment activities. If the majority, i.e. more than 50%, of the turnover, profit, assets and time employed are trading in nature, BPR can apply.

As well as enjoying income tax and VAT advantages, the hybrid company should qualify for business property relief as long as the rental activities do not overshadow the trade. Monitor this closely and frequently, looking at turnover, profits, and where assets and employees are used most prevalently.

Follow up

Farmer v IRC [1999] SpC 216
[Weblink]
HMRC guidance – SVM111220
[Weblink]
VAT Notice 706
[Weblink]