At LCN Legal, we count both property developers and investors amongst our clients. Over recent months, changes in tax legislation have meant that the way in which Entrepreneurs’ Relief can be applied to property development projects has not been entirely clear. A number of our clients have raised concerns as to how their business interests may be affected by these changes.
Leiza Bladd-Symms, Associate Director at LCN Legal, recently caught up with Stephen Hemmings, Tax Partner at Menzies LLP, in an effort to demystify the subject. Stephen’s contact details are set out at the end of this article.
LBS: What is Entrepreneurs’ Relief and why is it so valuable?
SH: Property developers who are considered to be carrying on a trade for tax purposes have been able to structure their projects in such a way as to be able to obtain the benefit of Entrepreneurs’ Relief at the end of the life of their project or even on a disposal of their business.
A typical structure would involve setting up a “special purpose” company to purchase land to undertake a particular development project. The development is then sold by the company and the proceeds of that sale distributed to shareholders as part of the subsequent liquidation of the company.
The Company suffers corporation tax on the profits and the shareholders receive a capital distribution which may qualify for Entrepreneurs’ Relief. Currently this produces an effective overall tax rate of 28%. However, corporation tax rates will be reduced to 17% from 1 April 2020 and recent speculation has suggested they may even drop to 15% in the near future. This could reduce the effective tax rate to only 24.5%.
By comparison, if the individual shareholders instead traded the property through a partnership or owned it directly, they could suffer tax of up to 47%. If they owned the property through a company and distributed the profits by dividend, this could even rise as high as 50.5% based on current tax rates.
This clearly demonstrates the benefits of careful planning and structuring from the outset. It is often too late to change the tax implications once the development is already underway.
LBS: What is required to be eligible for Entrepreneurs’ Relief?
SH: Entrepreneurs’ Relief is available on a disposal of shares or a capital distribution from a company in specific circumstances.
Broadly speaking, the individual needs to own at least 5% of the shares in the company and be a director or employee in the company, and the company needs to be trading. These conditions need to be met for a continuous 12 month period.
A classic pitfall for a property developer arises where the shareholders are not appointed directors in the company. Typically, this oversight cannot be rectified at a later date, as it becomes difficult to then meet the 12 month trading requirement, if the development is nearly complete and sold shortly afterwards.
LBS: The profits from property development projects are often distributed after the project has been completed, by winding up the project company. I understand that there have been recent tax changes (pursuant to the Finance Bill 2016), meaning that those distributions may now be treated as income rather than capital gains. Is that correct?
SH: There are some new rules, which should be considered by property developers and are discussed below. However, starting on a positive note, I should say straight away that by no means do the new rules apply to all such distributions, and with careful planning and consideration many property developers should not be affected by them.
LBS: Good news!
SH: In the Chancellor’s Autumn Statement of December 2015, the Government set out some proposals for targeted anti-avoidance legislation in respect of company distributions in a winding up, to apply in situations where they believe that taxpayers deliberately make arrangements to avoid or reduce income tax. New legislation was then included in the Finance Bill 2016 to apply to any such distributions made from 6 April 2016.
Where applied the rules act to convert a capital gain, (potentially subject to taxation at 10% if Entrepreneurs’ Relief applies (discussed in more detail below)), into a dividend distribution, (potentially subject to taxation at up to 38.1%). It is no coincidence that this legislation was introduced at the same time as the dividend tax rates themselves were increased. HMRC are well aware that such a disparity in tax rates leads taxpayers to seek out planning opportunities, and they are keen to restrict these as far as they can.
Taking a look at the new rules in detail, they will apply to a distribution which meets three specific conditions, broadly these are:
- The relevant company is a close company (or has been at some point within the last two years). This means that it can be controlled by 5 or fewer shareholders; for example, they hold at least 51% of the ordinary share capital between them.
- Within two years from the date of the distribution the individual who receives the distribution carries on a similar trade or activity as was carried on by the company, either directly or through another company. The condition would also apply if a person connected with the shareholder has an interest in a similar company within this period.
- Finally, there is a subjective condition which says that it is ‘reasonable to assume’ that the main or one of the main purposes of the winding up was to create an income tax advantage, or that it is part of arrangements with this same aim.
LBS: What does that mean for property developers and the potential availability of Entrepreneurs’ Relief?
SH: These new rules definitely create a level of uncertainty for some property developers, but in my opinion there is no need for widespread panic. The concern is that a distribution which would have previously been taxed at 10% is suddenly subject to taxation at up to 38.1%.
As all conditions have to be met for the rules to be applied, the first point to note is that a shareholder who is undertaking the development as a one off and will not be involved in any future property developments should not be concerned (as they would not meet the two year rule). For continuing property developers, the rules should definitely be considered further.
As background, there are widely drawn anti avoidance rules already in existence (the Transactions in Securities (TIS) legislation) which, amongst other things, can themselves be applied to distributions in liquidations. In my experience, the TIS rules are not commonly used by HMRC. These new rules, whilst to some extent a duplication, indicate a specific focus by HMRC in this area, and a focus which taxpayers have now been made clearly aware of.
I have obtained HMRC’s view on the target of these new rules in a conversation with the Inspector who was involved in writing the legislation. His view is that the main target will be what he referred to as “serial liquidators”, being people who continuously liquidate and set up new businesses. Primarily, this would be so called “phoenixing”, where a trading business is liquidated and then a very similar business set up by the same shareholder. The Inspector confirmed that in his mind this could also apply to property developers.
In terms of identifying these potential targets, it would be easy for HMRC to identify such taxpayers through easily available Companies House information.
At this point in time it is impossible to know for sure how commonly HMRC will attempt to apply the legislation. As mentioned above, there is existing legislation which arguably provides the same powers, and it may be that HMRC views the deterrent effect as the main benefit. These new rules have definitely received a lot of publicity. The next year or so should provide us with more of an idea. Interestingly, HMRC’s own estimates suggest that they expect to raise an additional £35m in tax in 2017-18, with this amount falling in successive years, and eventually being £10m in 2020/21. This seems to suggest that they do not expect to have to widely apply the legislation. That said, it is important to note that attitudes to tax collection consistently evolve, and the potentially uncertain economic times we are now facing may well change the expectations for these new rules over time.
We have discussed the matter with a number of our clients who we think may be affected. In our opinion it is still possible for developers to benefit from Entrepreneurs’ Relief. The fact is that most have strong commercial reasons for structuring their property development in this way, from setting up a development in a particular company at the outset to liquidating the company at the end of the development. Some of these reasons are set out below:
- a developer may instigate new projects with different sets of investors, thus requiring a new vehicle to carry out a particular project
- a commercial lender may require a separate clean vehicle to finance a particular project
- the commercial risk of a particular project can be better “ringfenced” in a company which does not hold any other assets
- a liquidation at the end of the project provides finality and commercial certainty
LBS: Absolutely. In my experience, special purpose vehicles are almost invariably used in property development projects, irrespective of whether Entrepreneurs’ Relief may be potentially claimable. And the financing and profit sharing arrangements vary considerably from project to project.
SH: We would strongly advise property developers to ensure that these reasons are clearly documented, in board minutes for example, so that their commercial intentions are precisely set out. This is the best defence against any suggestion that the arrangements were entered into to avoid income tax.
LBS: What should developers and investors be considering in terms of Entrepreneurs’ Relief when structuring new projects?
SH: The message is that Entrepreneurs’ Relief can still be available to property developers. If HMRC had wanted to completely remove this benefit for developers, they could just have included a carve out in the Entrepreneurs’ Relief legislation for property related activities. That said, it is important that developers carefully consider the structuring of their development projects, so as avoid an unintentional pitfall. Whilst the tax rules are forever increasing in complexity, the need to plan carefully has always been the case; these new rules are just one additional element to consider.
The very first point on Entrepreneurs’ Relief remains the fact that the company needs to be trading and not carrying on investment activities. This is something which needs to be demonstrated and documented in the intentions of the shareholders, the accounting records of the company and the commercial reality.
LBS: Is it possible to get advance confirmation from HMRC as to whether ER will be available?
SH: HMRC do not offer a specific clearance service providing certainty that it will not apply the new company distribution rules or indeed that Entrepreneurs’ Relief itself will apply.
However, it is possible to obtain HMRC’s opinion on specific issues where they agree that there might be material uncertainty. For instance, this could be in relation to one of the conditions of the company distribution rules, or whether they agree that a company is trading for Entrepreneurs’ Relief purposes. Where HMRC do not believe there to be genuine uncertainty on a specific matter they will not respond in full, although this in itself can provide some comfort to the tax payer.
When seeking assurance from HMRC it is important to seek specialist advice as this is commonly an intricate process and can involve multiple pieces of tax legislation.
LBS: What other tax issues should developers and investors look out for?
SH: One important point worth mentioning which has also been relevant since April is changes to Stamp Duty Land Tax (SDLT) rules which not all property investors and developers will be aware of.
From April 2016, commercial property SDLT rates moved to a slab basis (in line with changes the year before to residential property SDLT rates). This means that rather than paying the highest rate on the whole value (as was done previously) different rates are now applied to different slabs of consideration. Most people agree that this is a fairer system and should even out property value discrepancies which previously existed at each banding level. The Government also used it as an opportunity to change the overall rates paid.
The effect of the changes is that commercial property transactions below £1.05m pay less SDLT than before, whilst those above will pay more. In some cases, considerably more. The Treasury expect it to increase their coffers by £385 million in the current tax year.
In respect of purchases of residential property, there is now an additional 3% surcharge which will apply to property development and investment companies as well as to individuals purchasing where they already own residential property. This increases the highest rate of SDLT to 15%. It is worth mentioning that SDLT may be mitigated for transactions involving more than six dwellings in a single transaction and also where the property has some commercial element. Each transaction should be reviewed carefully on the basis of its own facts.
LBS: Stephen, many thanks indeed!
Corporate Tax Partner, Menzies LLP
020 207 465 1968