Introduction

The dynamics of owning a property portfolio in 2016 can create a challenge for even the most experienced investor. Since 2015, the Government’s tinkering with property taxes has left most property investors with the quandary of how to make their property investments work for them financially.

Coupled with the removal from 5 April 2016 of the long-standing 10% wear and tear allowance for residential properties, changes to the availability of tax relief for mortgage interest are due to start affecting rental profits from 2017/18. Tax entry barriers to property investment also now include increasing stamp duty land tax costs for buy to let and second homes over £40,000.

As is the case with many clients, property is commonly held personally either by the individual or as a partner in a partnership. These portfolios are often built up over a number of years, going through the property lifecycle and morphing into a property business. Holding a property in this manner allows freedom of choice in respect of the type of property (residential or commercial), whilst also offering the investor flexibility with the asset and access to income and capital, all within a reasonably straightforward legal and compliance environment. The question these businesses now face is what to do next?

Incorporation relief

One of the most common discussions advisors find themselves having of late with clients is around the concept of incorporating the property business; that is, taking the investors’ property business and incorporating it into a UK limited company. This is suitable for clients who run an active property business and want to create an income tax (“IT”) and capital gains tax (“CGT”) efficient environment.

Whilst the advantages and disadvantages of various ownership structures are often discussed, for many property investors who wish to consider a change of ownership structure, the CGT consequences of property incorporation can be prohibitive where incorporation relief (under section 162 TCGA 1992) is not available.

Incorporation relief allows the investor to defer their charge to CGT by rolling over the chargeable gain(s) arising on transfer of the property portfolio to the company against the base cost of the new company shares. Therefore, the gain becomes subject to CGT when the shares in the new company are disposed of. Incorporation relief is automatic, if all the conditions are met, and no election is required by the taxpayer.

There are three conditions to be satisfied:

1. The business transferred must be a “going concern”;
2. All assets (except cash) must be transferred to the company;
3. The consideration paid to the partner/individual by the company must be wholly or partly in shares.

While the partner/individual, when determining the availability of this relief, can manage conditions 2 and 3, the concept of “business” in condition 1 is critical. This article aims to consider the concept of “business” for the purposes of incorporation relief and identify what practical steps property businesses can take to ensure they qualify for this valuable relief.

Transfer of a ‘business’ as a going concern

Business is not defined for the purposes of Section 162 TCGA 1992, so HMRC agree that the word must be given its normal meaning. Whilst the term ‘business’ includes a `trade’, the two words are not synonymous.

The question arises whether the individual/partnership conducts a business for the purposes of incorporation relief, or whether it would be considered a passive investment. This is a question of fact and in the absence of clear definitions in legislation or from HMRC, each case must be judged on its own merits. To help the professional advisor and the taxpayer, relevant case law should be considered in conjunction with the clients’ scenario. Here we consider four of the key cases in this area.

Customs and Excise Commissioners v Lord Fisher [1981]

In the Fisher case which was heard in the High Court, Gibson J noted that, for VAT purposes, there was no definition of ‘business’, but went on to demonstrate six criteria for determining whether an activity is a business:

1. Whether the activity is a ‘serious undertaking earnestly pursued’;
2. Whether the activity is an ‘occupation or function actively pursued with a reasonable or recognisable continuity’;
3. Whether the activity has ‘a certain measure of substance as measured by the quarterly or annual value of taxable supplies made’;
4. Whether the activity was ‘conducted in a regular manner and on sound and recognised business principles’;
5. Whether the activity is ‘predominantly concerned with the making of taxable supplies to consumers for a consideration’; and
6. Whether the taxable supplies are ‘of a kind which...are commonly made by those who seek to profit by them’.

Although this case centred on determining the existence of a business for VAT purposes and not the availability of incorporation relief, it is helpful as it outlines six criteria for determining whether an activity is a business. Arguably, it is the concept of a property business being a serious undertaking earnestly pursued which should be the starting point for advisors when analysing the activities of a property business.

This case was also cited in the judgement of the controversial Ramsay case (Ramsay v Revenue and Customs Commissioners [2013]) reviewed later in this article.

American Leaf Blending v Director-General of Inland Revenue [1978]

Also cited in the Ramsey case and referred to in HMRC guidance is the case of American Leaf Blending (a Malaysian tax case heard by the Privy Council). This case highlights the fact that what may constitute a business, if carried on by a company, may not be a business if carried on by a private individual. Lord Diplock concluded that the mere receipt of rents from property owned by a partner/individual raises no presumption that the partner/individual is carrying on a business.

This case also provided examples of what activities can be considered the “carrying on of a business”. These examples included negotiations with tenants alongside labour intensive work such as moving machinery. Without these activities carried out by the taxpayer, it may have been argued that the ownership was merely a passive holding of investments.

Ramsay v Revenue and Customs Commissioners [2013]

Seen by many as the leading case in this area, the Ramsay case was the first to be heard on a claim for incorporation relief. Incorporation relief was initially denied in the First Tier tribunal¹ but allowed on appeal to the Upper Tribunal in March 2013².

Mrs Elizabeth Ramsey jointly owned a large property that was divided into ten flats and incorporated this ‘business’ in 2004 claiming incorporation relief.

The activities carried out by Mrs Ramsay included amongst others:

• Meeting the tenants;
• Payment of electricity bills for the communal areas;
• Changing insurance policy details;
• Unblocking drains;
• Oiling and re-attaching steel wires on garage doors;
• Clearing debris from garages;
• Returning post;
• Ensuring compliance with fire regulations;
• Installing fire extinguishers; and
• Putting in place refurbishment and redevelopment plans;

Despite these activities, the First-tier Tribunal (where the taxpayers were not professionally represented), found that those activities were normal and incidental to the owning of an investment property. Thus, the property letting activity was not a “business” for the purposes of incorporation relief and relief was thus denied.

However, the case was appealed by the taxpayer and heard by Judge Berner in the Upper Tribunal in March 2013. The Judge held that, as a matter of law, the First-tier Tribunal had erred in its approach and had addressed the wrong question. The question it should have asked was ‘whether the taxpayer’s activities in relation to the property constitutes a business,’ and he concluded that ‘the degree of activity undertaken by the taxpayer... was on the facts before the Upper Tribunal sufficient to amount to a business.’ The taxpayer’s appeal was thus allowed.

The judge used the principles found in the Fisher case to summarise his findings. He concluded that a business for the purpose of incorporation relief could include the letting of property providing the activities amount to a serious undertaking earnestly pursued with reasonable continuity, on sound and recognised business principles. The activities should be a kind that are commonly undertaken by those who seek to profit from them.

Rashid v Garcia [2003]

The Rashid case³ examined whether a property rental can be classified as an investment or a business and held that this classification is a matter of degree having considered all the evidence. In the case, the Special Commissioner was of the view that there was insufficient activity by the taxpayer to constitute a property business. Rather, he felt it was an investment that, by its nature, required some activity to maintain it and, on that ground, dismissed the appeal.

Although this case centred on determining the existence of a business for the purposes of social security contributions and not the availability of incorporation relief, again, it is helpful, as it suggests that property rental can be viewed as a business depending on the facts. Indeed, the Special Commissioner noted that he felt this case was ‘near the borderline’ but in the end was not satisfied that the facts supported the existence of a business.

Although the taxpayer was not successful in his claim of conducting a property rental business, the case demonstrates the types of activities required to prove the existence of a business.

These include:

• Arranging for repairs to the properties;
• Advertising for new tenants;
• Credit checks conducted on prospective tenants;
• Inventories made and checked;
• Rent collection;
• Arranging property inspections;
• Arranging cleaning of communal areas;
• Maintaining gardens; and
• Ensuring statutory obligations are discharged, e.g. ensuring gas and electrical equipment is checked annually etc.

Practical implications for advisors

The First-tier Tribunal judge in the Ramsay case noted that case law establishes ‘that where an individual asserts that a business arises, there is a presumption that unless proof of sufficient activity is established, that it is not a business’.

Accordingly, the burden of proof rests on the taxpayer. Advisors should ensure that clients not only have a qualifying business for incorporation relief, but they also have sufficient proof to substantiate the claim.

As well as the examples outlined in the case law above, advisors should consider ensuring that the partner/individual is carrying out, or suggest for them to start implementing the following activities where appropriate:

• Maintaining a diary of activity for each partner/individual including dates, times and actions;
• Proof that the client has an active interest in the local property market demonstrated by keeping in touch with local estate and letting agents;
• Ensuring that the partner/individual personally arranges or undertakes all aspects of the tenant arrangements, such as finding, vetting, negotiating the lease and lease renewals;
• Ensuring that the partner/individual personally arranges or undertakes all aspects of repairs and maintenance, including maintenance of communal areas and/or gardens;
• The establishment of a business bank account, which is monitored by the partner/individual personally for both income and expense payments;
• Business email and correspondence address including business cards; and
• Details of any redevelopment plans, or properties, which the partner/individual are considering buying, including properties that the business did not decide to purchase.

Conclusion

In the absence of a definition of “business” for the purposes of claiming incorporation relief, determining a client’s entitlement to the relief remains a subjective exercise. As the burden of proof lies on the taxpayer, it is imperative that the partner/individual maintains their records to ensure that any enquiry into the claim can be meet with a robust and convincing response. All evidence should point towards the property business being a serious undertaking earnestly pursued, and not a passive holding of investments.

As the property environment continues to come under further scrutiny and taxpayers owning residential property look at ways of improving their tax position, an advisor should have a selective and robust procedure in place for analysing client scenarios. This should help ensure that the business is a qualifying business for the purposes of incorporation relief, to avoid challenges in the future.

Ruth Todd is a Tax Manager in Private Client Services with BDO Northern Ireland.

Email: Ruth.Todd@bdo.co.uk