Incorporation Of A Property Partnership

Key points

• A property partnership can be incorporated with minimal tax charges.
• Property yield is often higher once in a company.
• Family wealth planning becomes easier in a corporate wrapper.

If you have a portfolio of rental properties owned either as an individual or in partnership, including a Limited Liability Partnership (“LLP”), then this article is for you.

What does it mean to incorporate?

Incorporation is the process of forming a new company. This can be either a newly formed company commencing a new business or via the transfer of an existing business to a newly formed company. This article focuses on the transfer of an existing business to a newly formed company.

Why incorporate?

There are many reasons why you may wish to transfer your business to a company.

One advantage of doing so is a possible reduction in the tax charge on retained profits. However, if all profits are distributed, the aggregate tax rate (corporate and personal) is higher than if the properties were held directly.

An added benefit of the lower tax rates in a company is that it can often lead to the property debt being repaid quicker than if they were owned directly. That is because the property yield, net of tax, will be higher than if they were owned directly.

What does the incorporation process involve?

Incorporation involves the disposal of the existing “business” to the new company. This entails transferring the existing business and its assets as a going concern. When incorporating a property partnership, the two main taxes to consider are Capital Gains Tax (“CGT”) and Stamp Duty Land Tax (“SDLT”).

CGT:

Usually, the transfer of chargeable assets (a business and/or its assets) is a disposal for CGT purposes. Where it is a transfer between connected persons, it is treated as a disposal at market value. Meaning a CGT charge would arise based on the market value of the properties less the price paid for them. If the properties have been owned for many years, this would likely trigger a significant tax charge for the owners.

However, the CGT legislation includes a relief from CGT called “incorporation relief” which enables a deferral of the CGT charge on the disposal of the business. It is an automatic relief which applies where:

• An individual or partnership transfers a business to a company as a going concern;
• The transfer includes all the assets, except cash; and
• The business is transferred in exchange for shares issued by the company to the individual/partners concerned.

The often quite contentious point regarding incorporation relief is the definition of “business”. Unhelpfully, a “business” is not defined in tax law. It can even mean slightly different things for different taxes. The issue for incorporation relief is that” business” is not extended to cover property letting activity.

There have been many a tax case through the courts which provide guidance as to the definition of “business” for incorporation relief purposes. For rental activity to be considered a business, the property generally needs to be let out on commercial terms and the activity carried out in connection with the letting is at a level typical of a business, rather than a passive holding of investments. This was highlighted in Elizabeth Moyne Ramsey v HMRC (The Ramsey case).

Rather helpfully, the Upper Tier Tax Tribunal ruled that residential property letting qualifies as a business for the purposes of incorporation relief. This went against a long-standing argument from HMRC that ordinary letting cannot usually be regarded as a business. HMRC’s view was that an increase in the level of activity undertaken to run a letting venture is not evidence that it is a business. Instead, it is simply commensurate with the investment property portfolio increase in size.

The tribunal disagreed with HMRC and instead stated that the existence of a business for incorporation relief is a question of fact. It will be a business where it meets certain characteristics:

• It is a serious undertaking earnestly pursued or a serious occupation actively pursued with reasonable or recognisable continuity.
• The activity is material in terms of turnover.
• It is conducted in a regular manner.
• It is carried out on sound and recognised business principles.
• Commonly made by those who seek to profit.
• All activities should be taken into account to assess the general degree of activity carried out, rather than individual activities in isolation.

The tribunal stated ‘in the context of property investment and letting, the same activities are equally capable of describing a passive investment and a property investment or rental business’. The key differentiator of whether letting is a business is ‘the degree of activity undertaken’. The tribunal refused to give an indication on the thresholds upon which activity should be deemed to be actively pursued but HMRC’s own manual (CG65715) specifically refers to 20 hours. Whilst this should not be relied upon, it can be used as a guide.

Stamp Duty Land Tax (“SDLT”)

SDLT becomes an issue only where properties are being transferred. Whether SDLT is chargeable, depends on whether the business is being transferred from an individual or a partnership (including an LLP).

Individual:

There is no special SDLT relief for properties being transferred on the incorporation of an individual’s business. SDLT would be charged based on the market value of the properties transferred (s.53 Finance Act 2003). This is irrespective of consideration actually paid.

Partnerships (including an LLP):

Where the business and property are transferred from a partnership, it is possible to eliminate the entirety of the SDLT charge. This is by virtue of special rules granting an SDLT exemption in transactions between a partnership and persons connected with the partnership (Part 3 Schedule 15 FA 2003).

Essentially, as long as the controlling shareholder(s) of the company created on incorporation have held all of the interest in the partnership before incorporation (considering the individual’s share in the partnership and any of his/her relatives who were also partners), the company will not be liable to SDLT.

Conclusion

The incorporation of a property partnership can be done without triggering CGT and SDLT charges. If you are part of a property partnership, then it is worth reviewing the structure and whether it would be beneficial to incorporate.

If this is something you want to explore further, please contact us!