The “Osborne Tax” is one nickname for a truly vicious tax change introduced by the Chancellor of that name not long before he “retired” from politics – and it’s also sometimes given the nickname “Clause 24” or “Section 24”, after the provisions of the Act that brought it in. What it consists in is the disallowance of interest on loans taken out by residential property landlords, and I’ll come on to describe it more fully shortly. Arguably it’s the hottest tax planning topic there is out there at the moment.
The “Moral” Argument
When George Osborne stood up in the House of Commons to deliver his Budget for that year (the changes first came into effect from 6 April 2017) he brought forward what can only be described as an attempt to justify the new tax imposition morally. What most people suspect is that the changes were actually a “blunt instrument” aimed at cooling the residential property market – particularly in London – but there was no whiff of this in the Budget speech. Instead he claimed that it was somehow “unfair” for landlords to get tax relief for the interest they were paying when individual homeowners didn’t. What this fatuous argument ignores is the fact that homeowners have no income against which to claim tax relief for their mortgage interest. Landlords are obviously in a completely different situation.
The effect is that loan interest is disallowed for higher rate income tax purposes, although it is still allowed for basic rate purposes, thus, incidentally, adding yet another layer of complication to our tax system. So, landlords end up paying tax on a higher profit than they have actually made.
Claude is a buy-to-let landlord who bought property at a “boom” time and borrowed heavily to do so. If the truth were known, he’s probably in negative equity at the moment – a distressingly familiar situation. All in all, he makes very little profit from his rental portfolio after expenses and, in particular, interest: so it’s a good thing that he has a “day job”: as a hospital porter. His summarised rental profit and loss account, in a year fully affected by the Osborne Tax (which is being phased in over four years) looks like this:
Because of his other income, the £20,000 profit uses up his whole basic rate allowance for the year. The profit for higher rate purposes is £150,000, rather than the “actual” profit of £20,000, and the higher rate tax on the £130,000 disallowed interest is £26,000. (That is, at 40% minus 20%).
So, Claude ends up paying tax of £26,000 on £20,000 income: an effective tax rate of 130%.
In the above example, Claude is in a terrible situation, financially, because he can’t even get out of this tax prison by selling the properties: because they’re in negative equity. He would end up with residual loans to pay back with no money to pay it back. His only way out of this situation, which he’s in thanks to the capricious actions of power-mad politicians, is to go bankrupt.
So, how does the ethical position sit here between the government and the taxpayer? Has the buy-to-let landlord got a moral duty to pay tax of over 100%? If he does anything, like restructuring his arrangements, to reduce this intolerable burden, is he a “tax dodger?”
The Limited Company Escape Route
Limited companies aren’t affected by the Osborne Tax, and still receive full tax relief for loan interest paid on residential property loans. So, there has understandably been a lot of attention recently given to ways of rearranging landlords’ financial affairs to bring about the position that the rental income, and the loan interest expense, are shown within the profit and loss account of a company rather than an individual. We’ll come on to the various ways of doing that in a minute, but before considering these options in detail, how about some more straightforward ideas for improving the position of Claude and others like him? We think there are three main such “straightforward” ideas:
Accept the hike in your tax bill, and put up rents to your tenants to compensate.
If you have any cash available on deposit, use this to pay off as much of the loans as you practically can. There’s already a huge difference between the interest you receive on bank deposits and the rate you pay on loans, and the loss of tax relief on the loan interest is tantamount to an effective huge increase in the interest rate.
Sell some properties to pay off loans.
“Non Company” Solutions
None of these non-company solutions are without problems, of course. Our own suspicion is that most of the “do nothing” brigade will have recourse to the first “solution” – of increasing rents. It may or may not be easy for them to put the rents up enough to compensate them for the extra tax cost, but without any doubt at all the result of this government tax “raid” will be inflationary. Ironically, considering the probable purpose of the tax hit was to cool down the property market, general increases in rents could even have the effect of increasing the attractiveness of buy-to-let properties to buyers who don’t have to borrow money: thereby leading to further property price increases.
It’s hard to know what George Osborne exactly expected landlords to do. In business, if your costs increase, you have to put your prices up. Only a profound ignorance of business could lead anyone to suppose otherwise.
The idea of paying off loans with spare cash is fine – providing you’ve got the spare cash.
And we’ve already seen that selling off properties, in order to reduce your loan exposure, isn’t necessarily as easy as it sounds. Even if you’re not in negative equity, it takes two people to make a sale, and the residential property market is extraordinarily difficult for sellers, particularly at the moment due to another gift to us from the government – known as the “Brexit crisis”. Remember, too, that selling properties is likely to give rise to liabilities to Capital Gains Tax: a crystallisation of this tax on “property price inflation”.
Less Ambitious Limited Company Planning
Companies don’t just have the advantage that they aren’t affected by the “Osborne Tax” loan interest disallowance. They also have the advantage of paying tax at a flat rate of 19%, so is there a way of making use of this fact short of the more heavy duty, structural solution of transferring the properties themselves to a company or a structure involving a company?
One idea you could consider is to set up a company which charges you, as the property owner(s), a fee for managing the property portfolio. This doesn’t have any direct effect on the Osborne Tax as such, because you’re still paying interest and still getting that disallowed; but it can have the effect of reducing the overall profits on which you are paying tax, and maybe, in some cases, could have the effect of reducing your income below the level at which you are a higher rate taxpayer, and the Osborne Tax bites.
So, a captive service providing company could be an answer in a minority of cases. Even so, you’ve got to consider some drawbacks to this idea, as follows:
Running a company costs money. You have to do accounts according to a set format, and there is inevitably an irreducible minimum of “red tape”;
If you pay the company’s income back out to yourself as dividend, of course, it reverses any benefit of reducing your marginal tax rate. So, you either have to find someone else that you don’t mind paying the dividends to, or you have to accumulate the money in the company: which isn’t going to suit most people;
If the company charges more than the VAT threshold in a year (£85,000 currently) it has to register for VAT and charge 20% on its fees. This pretty much nullifies any advantage of reducing the Income Tax; and
There has to be a worry that HMRC will query the allowability of the fees as a genuine expense against the rental profits.
The Two Structural Options
So having considered a number of ideas which have significant problems, and are likely only to work in a minority of cases, let’s come on to the structural solutions to the Osborne Tax that are being propounded. These are the limited company option and the LLP option.
The limited company option consists, quite simply, in transferring the property portfolio to a limited company, so that henceforth the company receives the rents and pays the interest. Ergo the company gets full relief and you effectively get full relief. An immediate problem, before we come on to the tax issues, with transferring a property portfolio to another ownership vehicle like this is the attitude of the mortgage lender. Is the lender going to want to transfer the borrowing, effectively, to another person? If they do, it’s likely they’ll use this as an opportunity to charge fairly chunky arrangement fees and valuation fees etc, and it is also likely that they will want to put your interest rates up. Some proponents of structural solutions therefore suggest that you should move the portfolio across beneficially only, and not legally. That is, the legal ownership on the land registry stays the same, and the identity of the borrower vis a vis the loan company stays the same: but the legal owner is now holding as nominee or “bare trustee” for the new entity.
There are some heavy weight legal considerations to take into account when doing this sort of thing, and so I would never suggest doing it without the benefit of proper legal advice. But there does seem to be some kind of consensus out there that the legalities can be dealt with effectively along these lines.
The LLP option is a little more complex, and it’s probably easiest to explain it in a diagram:
An LLP, in summary is a corporate entity which is taxed as if it were a partnership. In the LLP option the owner of the property portfolio is the LLP, and the limited company is just a partner in the LLP, with no separate activity of its own. Subject to some conditions which We’ll come on to, the idea is that the income of the LLP is allocated, in the annual division of profits, to some extent to the company member, with the result that the Osborne Tax doesn’t apply to that portion of the income.
So, both structures have in common the fact that the Osborne Tax is avoided by bringing about the position that the income is received by a company rather than by an individual. Both options therefore potentially involve income “rolling up” in a limited company’s balance sheet, in the form of ever increasing reserves. How you eventually unwind this situation is a complex matter, but as the purpose of the rest of this chapter is to consider the respective pros and cons of the company option and the LLP option, we won’t be going into this aspect in any detail, because it is common to both options. Suffice it to say here that this apparent mere “deferral” of tax can in some circumstances become effectively a permanent saving, depending on your long term “end game”.
Which to Choose?
So, how do you decide between the company option and the LLP option? It’s time to run through those pros and cons in detail. (These are then summed up below in a table.)
1. The company option has the advantage of relative simplicity. The company owns the properties, and therefore receives the income and pays the interest, and that’s that. The company structure has a long track record and is understood by most people. The LLP option, by contrast, is more complex and has a very short track record. It’s a kind of “hybrid” between a company ownership and individual ownership, and involves creative allocation of profits to be as tax efficient as possible. In the case of a company, it’s obvious that it’s the company which has to pay the tax on the whole profits.
2. On the face of it, there’s a Capital Gains Tax problem when you put your property portfolio into a limited company. This is because you’re treated as if you’d sold that portfolio into the company for its market value, and any gains on the sale come home to roost. Fortunately there’s a relief known as “Incorporation Relief” which applies in all cases where a person transfers a “business” to a limited company, and the company issues shares to that person in exchange. So, is your property portfolio a “business”? The answer is it might be or it might not be. At one extreme you’ve got a single flat owned by an old lady which she receives rents from. At the other extreme you’ve got a huge portfolio managed by an office full of full-time workers. Clearly the latter is a business, but is the former? If you’re somewhere in the spectrum in between, are you on the business side of the line or not? In short, relief from CGT, when you’re transferring to a limited company, depends on the interpretation of an undefined, and very vague word, which is the word “business”. Turning to the LLP structure, CGT can also apply when you transfer into this: but it’s much more straightforward and black and white to avoid this.
You don’t claim Incorporation Relief, as with a company, but you make sure you write the LLP agreement in such a way as to avoid there being any deemed disposal of the properties – using the “transparent” nature of the LLP. So, the LLP structure has the advantage that freedom from CGT doesn’t involve tricky questions of interpretation.
3. Now we come on to the even trickier question of Stamp Duty Land Tax (SDLT). In the “vanilla” situation, the transfer of one or more properties to a company is chargeable to SDLT as if it were a purchase by that company at market value. The exception to this, which is what proponents of the company option use, is where the transfer is going from a partnership to a company connected with that partnership. For SDLT, then, we have a different question: “is the transferor a “partnership”? This is generally a more difficult question of interpretation than the “business” issue that applies for CGT. If husband and wife, say, own three or four properties jointly, are they in “partnership”? Personally, we would say no. The word partnership generally connotes some kind of trade. Those promoting the company option often, ironically, have recourse to LLP’s to get around this issue. They recommend to clients that the portfolio should go into an LLP first, and remain there for say two or three years. It’s then transferred from the LLP to a company, and because an LLP is automatically treated as a partnership in all circumstances, you’ve ticked the SDLT relief box.
But what about the old anti-tax avoidance case, which holds that, where you have a series of transactions which are preordained, and it has steps inserted which have no purpose other than to avoid tax, the government can ignore the inserted steps? Surely the two or three years whilst the portfolio is owned by an LLP is an inserted step, which should get ignored? The result for SDLT then would be the same as a straightforward transfer straight to a company: i.e. SDLT on the market value. The proponents of limited companies say they get around this by avoiding the series of transactions being “preordained”. At the time you put the properties into the LLP, you’re not sure whether you’re actually going to go on to the next stage, which is a transfer to a company. But we’re not convinced. We think in hindsight it’s going to look very much, to the taxman, as though you always meant to do it.
4. Income drawdown, after you’ve transferred the property portfolio, is much easier in an LLP. To the extent that you’ve put value into the LLP, you can draw this value out again tax free, because it’s just a return of your capital. With the company option, the normal situation, under Incorporation Relief, is that you haven’t got any amount owed to you by the company that you can then draw on tax free – because the company has issued you shares in exchange for your properties. It’s true that you can then redeem these shares, but the cost of doing this is that the capital gain you deferred under Incorporation Relief becomes chargeable.
Some proponents of the company option have come up with a “clever” way around this, which involves carving out a liability in your favour prior to the transfer. But you have to take this with the caveat that it’s a scheme designed simply to flout the clear intentions of Incorporation Relief, and this, to us, is always a danger signal.
5. Under the LLP route, if the property portfolio increases in value as the years go by, this results in more credit available for you, as the LLP member, to draw down. Revaluation surpluses are credited to the members’ capital accounts, and, unlike the situation with limited companies, revaluation surpluses can be drawn down in LLP’s. Turning to the company option, this ability to draw down future increases in value doesn’t, as far as we know, exist. You are stuck with the value of the properties on the date they went into the company (if you can even draw down on this) and once that’s gone, you can only take money out of the company in the form of taxable income. A major plus for the LLP option and minus for the company option, in our view.
6. Within an LLP, because it is “transparent” there’s only one charge to capital gains taxation when a property is sold. Under the normal form of the LLP structure, all capital gains arise to the individual. So, given that we’re talking about residential property here, that’s a 28% tax charge, levied directly on the LLP member, whenever a property is sold. In the company structure, it’s the company which pays tax on the gain, of course: and that’s at the lesser rate of 19%. So is the capital gains treatment an advantage for the company option?
Our answer to this would be “not really”. The problem with gains accruing to companies, of course, is that if you want to draw that money out personally, you’re likely to have to pay tax, either as income or, if it is on final winding up of the company, as a capital gain. So, you have the notorious “double charge to tax” when a company sells an appreciating asset like a property. Of course, if you are looking to keep the money within the company forever, this isn’t a problem, and indeed the company gives you a better outcome. But you might ask the question, what is the use of money, if you have to keep it in the company forever?
In summary, this is a much more ambivalent issue, and really depends on what your long term plans are, both for holding the property, reinvesting the proceeds in more property, and for winding up or retaining the structure long term.
7. There’s no CGT free uplift on death for properties owned in a limited company. With an LLP there is, because, again, of its “transparent” nature. Let’s give an example to show what a huge difference this can make:
Mrs X inherits a property on her husband’s death, at a time when it has a value of £200,000. It originally cost the husband £50,000 many years ago. She sells the property shortly afterwards for the same value, and pays no Capital Gains Tax, because £200,000 is the sum she’s deemed to have acquired it for. Mrs Y’s situation is identical except for the fact that what she has inherited, strictly speaking, is the shares in a property company which acquired the property for £50,000 many years ago, and which is now worth £200,000 because the property that the company owns is worth that Mrs Y arranges for the company to sell the property for £200,000 shortly afterwards. Commercially this is an identical situation to that Mrs X found herself in. But the difference is that the company has to pay Corporation Tax on a chargeable gain of £150,000, because its base cost is the same as it always was. The company hasn’t died. To add insult to injury, Mrs Y then has a tax bill of about £50,000 personally on drawing the gain out of the company.
This lack of CGT uplift on death, in the context of a property investment company, is a very major problem with property investment companies. Where, as often happens, a property company passes down through many generations of a family, some quite bizarre results can come about. We’ve known a company which has luxurious flats in High Street, Kensington which have a tax value of £5,000: meaning that on any sale, virtually the whole proceeds will be subject to tax.
8. When we come on to Inheritance Tax planning the situation is again markedly different between the two options. If you want to give away some of the value of your property portfolio, and it is held through a company, usually the only way to do this is to transfer shares in the company to the intended recipient. The lion Capital Gains Tax is in the path, when you come to planning along these lines. Any transfer of shares in an investment company to another individual will trigger a capital gain, on the difference between the current value of those shares and their original cost to you.
By contrast, our view transferring the capital in an LLP, which is the equivalent under the LLP option, can be done without Capital Gains Tax. The proponents of the company option have actually got quite clever here, and sometimes advocate the use of “funny shares” which have a low value initially but which enjoy all the benefit of the increase in value of the underlying portfolio. We’ve no doubt these arrangements, as well as being clever, can sometimes work if put in place properly. But you’ve still got the disadvantage of a lack of flexibility, because usually this sort of structure will have to be put in place at the outset, and to do that you’ve got to know exactly who you want to benefit and by how much. Changes in the capital structure of a limited company later on in its life are difficult to bring about without triggering Capital Gains Tax disposals. An overall summary would be that the LLP structure is much more flexible from the point of view of future Inheritance Tax planning, for this and certain other reasons.
It may help if we set out the above list of pros and cons in a table, as follows:
Conclusion
To conclude our review of the respective merits of the two options, it’s not possible to say, black and white, that one is “better” than the other. But, the combination of the different factors above leads us personally to the conclusion that we would tend to favour the LLP option more often.
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