This article is contributed by Stephen Hemmings, a corporate tax director at accounting firm Menzies LLP who has 8 years’ experience of advising clients in the property sector.
A popular way for private investors to purchase a stake in the UK property market is to access the resources and expertise of property developers through joint venture arrangements. From the developer’s perspective this gives them access to additional capital.
Property joint ventures can be structured in a number of ways. Investors will need to consider the tax and legal aspects of the nature of the property business they are undertaking, how this should be financed and an appropriate vehicle to carry out the business.
A range of vehicles can be used including
- UK companies
- Non-resident vehicles; and
- Unit trusts
In this article we have not considered some of the more complex vehicles which can be used, and focussed only on UK companies and partnerships. Other options often prove cost prohibitive for smaller investment amounts.
This article summarises at a high level the tax implications of using company and partnership structures as well as other issues and considerations which need to be taken into account in relation to investing in such property businesses. An illustrative tax rate table is also included at the end.
The use of a UK company is perhaps the simplest option from the perspective of the investor. A company can be set up through funding provided in the form of share capital, loan capital or a combination of the two. (The potential benefit of loan funding is discussed in more detail later in this article). Typically the share capital of the company is split between the property developer and the private investor.
The company will be taxed on any profits received, for example from rental income or property disposal. The UK corporation tax rate is currently 20% for small companies (those with profits less than £300,000) and 23% for large companies (those with profits over £1.5m) with a marginal rate of tax applied between these two numbers. From 1 April 2015 it is anticipated that all corporation tax rates will be unified at the lower rate of 20%.
It is possible that the actual development of the property is carried out by a separate entity, which is part of the developer group. This entity may then charge a fee for any construction work carried out on the property. Where this is the case the developer may hold a smaller portion of the equity in the property holding company.
Returns are taxed in the hands of individual investors at an effective tax rate of up to 30.6%, through dividend distributions, or up to 28% if distributed as capital during a liquidation at the end of the lifecycle of the company. This provides an effective tax rate of up to 46.5% from the investor’s perspective (assuming they are higher rate tax payers).
Where a number of properties are held it may make commercial sense to hold each of them in a separate company, underneath one group holding company. This can also provide transaction tax savings.
The direct acquisition of UK property is subject to Stamp Duty Land Tax (SDLT), currently at rates between 0% and 7%, depending on the value of the property purchased and whether it is residential or commercial. A table of current SDLT rates is included at the end of this article.
A regime has recently been introduced to impose a 15% charge on purchases of residential property by a company where the market value of the property is over £2 million. There are specific exemptions from this charge which would need to be considered carefully. As an aside, there is also a separate annual charge in respect of residential properties with a value of over £2 million in certain circumstances, again subject to certain exemptions. For example, this charge should not apply if the property is let to a third party on a commercial basis and isn’t, at any time, occupied (or available for occupation) by anyone connected with the investor or the developer.
In contrast, if instead the purchase is made by acquiring a UK company holding the property, stamp duty of 0.5% on the value of the company shares applies. If the company is debt financed then the net value of the company can sometimes be very low, further reducing the stamp taxes payable. Where the company purchased is a non-UK company there may be no stamp tax payable.
On a subsequent disposal of a property owning company, whilst the stamp tax saving is technically a benefit for the purchaser, it is common for both parties to agree to share the saving.
It is clear that the level of transaction tax saving will depend on the value of the property being acquired and sold. This saving also has to be balanced against the administrative burden of running additional companies, and also the fact that commercial investors may not wish to acquire companies that could have inherent tax gains or other previously undisclosed liabilities.
The use of a partnership can provide more flexibility in respect of the way that returns can be allocated between investors. Returns do not have to be allocated in proportion to capital invested and can be varied from year to year. That said, the UK authorities are currently implementing tax avoidance legislation around the use of partnerships, so care will need be to taken to ensure that any structure does not fall into these rules. The rules are only currently in draft form, subject to consultation, and we have not considered them further for the purposes of this article.
Property partnership joint ventures are commonly structured in the form of a Limited Liability Partnership (LLP), which from a commercial perspective provides limited liability protection to its members, in a similar way to that which a company would provide to its shareholders.
From a tax perspective the key difference for investors is that the partnership is treated as tax transparent so that investors are taxed on their proportion of the business held as it arises. This is different from a company where they will only be taxed on income received as distributions (dividends) from the company. Historically, the use of partnerships has been viewed as advantageous as a layer of taxation is removed, when compared to the use of a company as an intermediate vehicle carrying on the business. Due to the lowering of the company corporation tax rates, this advantage is no longer as pronounced.
UK tax-resident partners will be taxed at a rate of up to 47% (including national insurance) on any trading income on disposal or ongoing rental income, and up to 28% on disposal gains that are deemed to be capital. More detail on the nature of the income to be derived from the business is discussed below.
In a company, profits can be retained and reinvested without any immediate direct tax consequence for the shareholders, whereas in a partnership members are subject to tax on underlying profits in any case.
Investors should consider a couple of points in respect of partnerships to prevent them from falling into unwelcome tax traps.
The rules concerning the taxation of assets held in partnerships are not enshrined in statute, but generally follow an HMRC practice statement dating back to 1975. It is often difficult to relate specific circumstances to the HMRC practice document and careful consideration needs to be made of particular transactions. One area of caution arises in circumstances where members join the partnership, which in certain circumstances can trigger an unexpected tax charge in the hands of the existing partners, based on the increase in market value of assets since their own acquisition, without them having receiving any direct consideration. This is referred to as a dry tax charge. It is important that tax advice is sought when establishing the partnership and at the time of any changes in partner ratios.
Non-UK tax resident investors should also be especially wary when investing into a partnership that is carrying on a property business, as they will be subject to tax on trading income sourced in the UK. They would also be required to file a UK tax return, which would not necessarily be the case if they were just receiving dividends from a UK company.
Nature of business
Trading vs investment
The intention that the business has for the property will affect the tax treatment, whether held in a partnership or company. Where the intention is to develop the property so that it can then be resold in a short time frame at a profit, this is generally considered to be trading. This would generally be the case for a typical residential property development where the intention is to buy the property, develop it and then sell around two years later, and not hold the property to produce rental income.
Where the intention is to develop the property, hold it to generate income from rental activities and achieve capital growth over a period of time, the tax treatment is more likely to be that of an investment.
When considering the intention for the properties, a number of factors are taken into account including the accounting treatment, length of time held, and information contained in formal documentation such as board minutes.
The differences between the two treatments, trading versus investment, affect individual investors in a number of ways, some of which are discussed below.
Where the property is held in a partnership, any arising profits or losses are taxed directly in the hands of the investors. If the property is treated as an investment for tax purposes, the profit on any future disposals is taxed as capital gain (rather than as a trading gain) and subsequently at a lower tax rate for UK tax-resident shareholders (up to 28% as opposed to up to 47%). For non-residents the treatment is even more significant as they are not subject to tax on capital gains (although it is proposed that this exemption be removed from 1 April 2014 in respect of UK residential property but not commercial property).
Where the property is held in a company the differences are likely to be less significant for the investor. One key point does arise if the property holding company itself is non-UK resident, as it would not be subject to any tax arising on a capital gain from an investment property disposal (subject to the above changes or on residential property valued over £2 million), but would suffer tax on any arising trading profits.
On the other hand, Entrepreneurs’ Relief may be available to an individual holding a 5% stake in the business deemed to be trading (this can apply to both companies and partnerships). This applies to tax any capital gains at a lower rate of 10% (as opposed to up to 28%). This scenario may arise, for example, where the individual is a director in the company and receives a pay out on liquidation of the company following the property disposals.
Finally, capital allowances, which can provide tax relief on some capital expenditure in relation to the property, are only available in respect of investment property.
As you can see it is important that the nature of the business is clearly identified at the outset, to allow the tax consequences to be considered.
Loan vs equity
Another key point from a tax perspective is the means by which the property business is funded. Investors can provide funding in the form of equity or a mixture of equity and loan financing.
On the basis that any loan funding is provided on arms-length terms the property business should be able to offset future income against financing costs, such as interest. This will also apply in respect of third-party financing from external providers. This can make a significant difference to overall returns.
For UK tax-resident investors, loan financing can provide a tax-efficient means of extracting future profits from a company. Profits can be withdrawn in the form of loan repayments (up to the value of the loan account) without suffering any tax consequences. In contrast, if there are no loan accounts, surplus profits would be withdrawn through dividend distributions and subject to tax at an effective rate of up to 30.6%.
As you can see from the above, the structuring of a property business can have a significant effect on the tax treatment for investors and can greatly affect their overall return on investment.
In summary, some key points mentioned above include:
- Partnerships can provide more commercial flexibility than a company, in terms of the allocation of returns.
- As partnerships are tax transparent, their use removes the additional layer of tax inherent in a company structure. However, the level of headline tax saving will depend on the nature of the returns from the business and the investor’s own circumstances.
- From a practical perspective the use of a partnership structure means that the investor is taxed on profits as they arise, and can create additional tax compliance work for an investor.
- The use of loan funding can be tax efficient.
- Recent and upcoming changes to tax legislation concerning partnerships and the taxation of residential property may need to be monitored and considered.
- Tax reliefs such as capital allowances may be available to mitigate the level of taxable profits.
It is important that the intention for the business and its structuring is carefully considered at the time of implementation, in line with the investor’s needs, as there is no one-size-fits-all approach. This article has not attempted to cover all scenarios but hopefully has covered at a high level some key areas for consideration.
Illustrative effective tax rates for individuals holding a property business through a company or partnership
The above table is a very basic illustration which makes a number of assumptions. The figures in relation to the company include the combination of corporation tax and tax paid by the individual on extraction. The workings assume that no specific tax reliefs are available (except for the below), that the company pays corporation tax at 23%. The table ignores the fact that in practice the companies may choose to retain and reinvest profits.
It is also assumed that the investors are UK tax resident higher rate tax payers.
* This assumes that entrepreneurs relief is available to the individuals on a disposal of a qualifying interest in a trading company, otherwise the relevant percentage would be 44.5%.
Stamp Duty Land Tax