The Big Battle
There is at present a huge war going on for the soul of the buy-to-let landlord community. Two sets of promoters of tax avoidance “arrangements” are ranged up against each other: and they aren’t taking any prisoners. Whom is the poor benighted landlord to believe?
Companies or LLP’s?
What this fighting is all about, of course, is George Osborne’s infamous “Clause 24” tax. Using some of the most specious reasoning ever set out by a front bencher in the House of Commons (and this is saying a lot!) Mr Osborne, as Chancellor, announced, a matter of years ago now, that higher rate income tax relief was being withdrawn for interest paid on buy-to-let property portfolio loans.
For many people, (we know some of them) this is going to amount to effectively an over 100% rate of tax on their income. For those who are highly geared – that is those who have a high loan to value ratio in their property portfolio – the actual profits they are making, after paying the interest, may be little or nothing, or even losses. Nevertheless, they will have a tax charge, as far as 40% tax and above is concerned, as if they were paying no interest at all.
The logic underlying this change in the law absolutely defeats us. But it’s already coming in, and with effect from 6 April 2020 the disallowance will be complete.
Ways out of the morass
A lot of people will be seeking what might be termed “non structural” escape routes from this terrible situation. Some, for example, will be more less forced to sell some of their properties to pay off loans: and this, of course, may be precisely what Mr Osborne wanted to happen. Others, though, will be unable to do anything, and may even be in negative equity. For them, the “sell properties” route is the road to the bankruptcy court.
Hence the popularity of the limited company “solution”.
Because limited companies are actually immune from the new rules, a company can borrow as much as it likes to acquire buy-to-let properties, and will get full relief for the interest it pays against its corporation tax liability. This simple fact has given rise to a massive tax planning industry nationwide, of those pushing landlords into incorporating their portfolios as company owned ones.
But what is this we hear? The faint sound of the trumpet from an approaching and opposing army! These are the promoters of the LLP, or “hybrid” structure, as an alternative to the company.
Both sides in this battle of the structures seem to have little time for the other: so who are you to believe?
This article tries to answer that question. Let’s draw up our battle lines.
What are the options?
Just to sum up where we’ve got to so far, then, a buy-to-let landlord, with interest liabilities which are big enough to make the new rules hurt, has fundamentally got a choice of four responses to Clause 24:
- Do nothing, and suffer the supra normal income tax rates that will result;
- Go in for a “non structural” solution, such as selling properties to reduce borrowing;
- Transfer the property portfolio to a limited company; or
- Transfer the portfolio to an LLP with a limited company as one of the partners.
Assuming you don’t want to go down either of the first two roads, you’re going to need a proper understanding of the tax consequences of restructuring your portfolio. So, here’s a handy “cut out and keep” summary of the pros and cons.
From the point of view of simplicity, the company option wins over the LLP option. Instead of an arrangement involving two corporates and all of the individuals, you simply have a company owning the portfolio, and the company itself having its shares owned by the individuals. You have “interposed” the company between you and your properties, in ownership terms. The company owns the property, the whole property, and nothing but the property, and there’s no doubt, therefore, that the rental income deriving from the portfolio will belong to the company – at least initially – and to no one else.
With the LLP/hybrid structure, the position is by no means so clear cut. An LLP, as readers of these pages over a long period will be well aware, is a strange kind of hybrid entity, which legally can own assets but, for tax purposes, is treated as if it were a partnership. The members of the LLP, in this particular case, will be both individuals and limited companies, and the income derived from rents will be shared out amongst the members. The idea is, of course, that the share of rents which goes to the company will not be subject to the Clause 24 interest allowability restriction.
But already you’re running into complications, here, because there are special rules for hybrid LLP’s of this sort restricting the amount of net income you are allowed to attribute to the company member. So, the planner has to get over this restriction in some way, such that a sufficiently high proportion of the rents can be attributed to the company and escape the clutches of the Osborne tax.
So, the company promoters win easily on simplicity.
Tax on the way in
It is this part of the battlefield where the fighting is arguably at its fiercest. LLP proponents point to two sorts of uncertainty which exist where you are putting a property portfolio into a limited company.
First, capital gains tax normally arises when you transfer an asset to a connected company, based on the market value of what you are transferring. To get around this, the limited company proponents need to fit the situation into a specific CGT relief known as “Incorporation Relief”. This applies where you transfer a business to a company in exchange for shares. The uncertainty here, which will be more acute in some cases than others, is as to whether what you are transferring to the company is a “business”. This is a supremely vague word, but HMRC are known to hold the view that an isolated investment will not normally be a “business”. If you don’t pass the vague “business” test, you’ve got capital gains tax to pay on the market value of your whole portfolio. And probably no money to pay it with.
The proponents of the LLP route, on the other hand, do not need a favourable interpretation of any woolly terms like the term “business”. Providing the LLP agreement is drafted correctly, it should be fairly black and white that there is no disposal of the portfolio when you put it in, and hence no occasion for HMRC to charge tax.
Stamp duty land tax (SDLT) is the other threat. Again, the normal rule is that property transferred to a connected company is treated as being acquired by that company at its market value, and SDLT charged accordingly. With the soaring rates of SDLT we are now seeing, this could be a painful, indeed unmanageable, cost of doing the incorporation.
But the wily proponents of the Company Solution have an answer to this as well. Where property is transferred from a “partnership” to a company which has the right type of connection with the partners, there is no SDLT, for complex technical reasons which we won’t go into. But is a property portfolio a “partnership”? If it’s owned by one person, clearly not. Most often, in practice, such a portfolio is held by a couple, normally husband and wife. Is a husband and wife held portfolio a “partnership”? Unless there is a trade going on, there is severe doubt on this matter.
So, the company proponents, or some of them, suggest that, to get round this, you should use an LLP after all! In their case, though, this is merely a temporary measure, to ensure that the holding structure is deemed (by compulsory statutory fiction) to be a “partnership” prior to its transfer to the company. So, some people are suggesting, for example, a two year holding period within an LLP, followed by full incorporation, going down the limited company route.
We have to admit to feeling a little queasy about this device, though. Although it’s not talked about so much these days, there’s a legal principle named after a 1970’s tax avoidance case, referred to as the “Furness v Dawson” principle.
Under this principle, where there is a preordained series of transactions, into which steps have been inserted which have no purpose other than tax avoidance, the courts feel that they can disregard the inserted steps. Doesn’t this look a bit like what is happening here? You put your portfolio into an LLP, knowing that you’re going to transfer it out to a company later. So, the inserted steps, which are just there to avoid SDLT, are the transfers in and out of the LLP.
We believe that the company proponents get round this by saying that the transfer to the LLP is open ended: that is, the portfolio may or may not be transferred out to a company later. We can imagine an Inspector of Taxes looking very cynically on this argument when it is finally trotted out, though.
The rules relating to SDLT charges on introducing property to an LLP are completely different, and don’t depend on the interpretation of the word “partnership”, or indeed any other such vague and woolly word. The rules, in fact, which are a recent vintage, are very clear cut and, again, it is easy to arrange the LLP agreement to avoid an SDLT charge within the regime set out in these rules.
Tax on income going forward
This is an area where the LLP army feels they have got the other side on the run – but have they?
If you put your property portfolio into an LLP with a company partner, and then attribute income to the company, you don’t necessarily have to then proceed to pay out the company’s income to you as a dividend. Instead, you have the option, basically, of drawing down on the possibly very substantial credit balance you have with the LLP as a result of introducing the portfolio. So, in many cases, you can become a basic rate taxpayer for the indefinite future, no matter what the size of the rents, or the amount you draw out of the business. So, the LLP is a powerful tax planning structure, potentially, Clause 24 or no Clause 24.
The company owners, however, gloat the LLP proponents, have to pay full income tax at their marginal rates on all of the income they actually take out of the portfolio. The reason for this is that, under incorporation relief, you need to issue shares in return for the whole portfolio, and therefore you have no easily drawable credit left, going forward.
All the time, though, the company proponents have been busily working away undermining the LLP boys’ argument. A scheme has been devised by very clever people under which you can, apparently, have your “cake and eat it”: that is, you can claim incorporation relief whilst still bringing forward a large credit balance in your favour, that you can draw down tax free.
In response to this, the LLP proponents merely express an uneasiness about the highly contrived nature of this “clever” solution to the problem.
Capital Gains Taxation going forward
This is probably the trump card in the LLP/hybrid camp’s hands. There’s something rather final, after all, about the transfer of a property portfolio to a limited company. Any extraction of that portfolio from the company in the future will give rise to tax, and, if you want the money yourself, as an individual, this will be two layers of tax – once in the company and once in your hands as an individual, on extracting the money from the company. The LLP route, though, if drawn up properly, means there is only one layer of tax, which is on you personally. This layer of tax will be a significantly lesser burden, in most circumstances, than the double tax charge that the company lets you in for.
As an additional sting in the tail, there is no rebasing of the value of company held property when the shareholders die. So, we’ve known instances where a property company, which was set up 50 years ago or more, has large and prestigious flats in Central London in at a tax value of a few thousand pounds each. Any sale of these properties is going to result in a huge tax charge. By contrast, properties held through the LLP/hybrid structure are subject to an uplift to market value on the death of the relevant LLP member. Broadly speaking, the inheritance tax liability under both routes is the same.
Against this, all the company proponents seem able to bring forward is the fact that the properties are rebased up to their value on the day of incorporation. It’s true that this isn’t the case where a portfolio is put into an LLP: but we think the company proponents may be guilty of something of a “quick fix” mentality here, without considering the harmful long term effects of incorporating a buy-to-let property portfolio in a limited company.
So, after all that, who is right? Is it the company proponents or the LLP/hybrid proponents? Of course, it would be easy for us to sit on the fence and come up with some kind of anodyne answer to this question like “it depends on the facts and circumstances of each case”. Undoubtedly there will be situations which are comparatively unusual and therefore “buck the trend”. However, it’s the incalculable long term damage that could be done by simply transferring the portfolio to a limited company that swings the balance for us, in general terms and in normal circumstances. In fact, we would be inclined, ourselves, to favour any of the other three options listed at the outset of this piece than commit ourselves to a company held portfolio long term, for all the reasons, and bearing all the pros and cons in mind. A limited company, as we’ve said before, is very much a taxation “straitjacket”, with none of the open-endedness or flexibility of personal or LLP ownership of assets.
By all means take proper detailed advice, which fits your own particular situation: in fact, we strongly recommend you do so. However, inevitably you are going to be talking to somebody who is parti pris on one side or the other of this battleground: and hopefully the above description of the strengths and weaknesses of each side’s position will help you pin the adviser down on specific potential problems with his preferred line of action.