Clients may have read with alarm some recent reports about another proposed change to buy-to-let taxation laws.
Earlier this month, the Law Society wrote to HMRC about new clauses in the Finance Bill 2016. It expressed concern that, under the new rules, buy-to-let investors could be liable to pay income tax, rather than capital gains tax (CGT), on the disposal of UK property.
This would entail a maximum charge of 45%, rather than 28%.
In the days since, a number of online landlord communities and news blogs have covered the story. Here we seek to provide some background and clarity to the proposals, and what they might mean for you.
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A technical note published in March 2016 outlined details of new legislation that aims to prevent offshore property developers avoiding tax on profits from UK development activity.
To do this, the legislation introduces a corporation tax or income tax charge on trading profits from the disposal of UK land. Current corporation tax rules charge tax only on profits attributable to a ‘permanent establishment’ (PE) based in the UK. Similar rules exist for income tax. This allows overseas companies to shift their tax obligations in order to avoid paying some UK tax.
The legislation was part of Budget 2016 – the last delivered by former chancellor George Osborne. Ministers introduced it into the Finance Bill 2016 as new clauses 75 to 78. If the Bill as it stands receives royal assent, the new rules will have effect for disposals made on or after 5 July 2016.
Ministers inserted the new clauses without warning
Disregarding the technical note, the government did not consult on the draft legislation before its introduction. The Law Society believes that the process is “inconsistent with the government’s commitment to proper consultation on substantive legislation”.
Indeed, the Law Society’s comments – first published on 19 July – appear to be the first public recognition of the change. The circumstances have prompted news outlets to refer to the new law as a “stealth” tax on landlords.
The Tax Information and Impact Note (TIIN) for the new clauses states that the measure targets overseas developers. It outlines its policy objectives to ensure that
offshore structures cannot be used to avoid UK tax on profits that are generated from dealing in or developing land in the UK. The aim, it claims, is to
level the playing field between UK and offshore developers.
Chief Secretary to the Treasury David Gauke reiterated this position in a Public Bill Committee on 7 July:
“This measure is targeted at those who have a property building trade; it does not impact the tax profile for investors in UK property.”
Despite the law being aimed at overseas companies, the new law does not apply only to offshore structures. Rather, to fulfil its objectives, it “[removes] the territorial restriction” so that tax applies to UK-based land transactions, irrespective of residence.
Companies already pay corporation tax, rather than CGT, when they dispose of assets. So in the case of companies, the draft legislation appears to achieve its aim.
Furthermore, non-corporate property developers already pay income tax when they sell a property. HMRC views sales proceeds as trading income if the purpose of a business is to buy and sell property.
The most worrying parts of the new legislation are in clauses 77 and 78. These sections give rise to an income tax liability for a “profit or gain from a disposal of any land”, subject to conditions. These conditions relate to the seller’s intention at the time of acquisition. If “the main purpose” was to make a profit from the disposal of land or property, whether developed or undeveloped, the seller will incur an income tax liability.
This seems to create a broad range of circumstances in which HMRC will treat sales proceeds as trading income. As the Law Society observes, capital growth is an essential consideration for buy-to-let investors. There is a danger that this wide-net approach will catch out buy-to-let landlords, many of whom invest for a mixture of capital growth and rental income.
Response from the National Landlords Association (NLA)
Initially, the NLA took the view that “despite the poor wording”, the legislation would not impact landlords.
Following the Law Society’s comments and subsequent press coverage, the NLA sought comment from HMRC. An HMRC official stated that the changes would not affect property investors.
The Law Society welcomed the assurances, but encouraged the government to clarify this point in the Bill.
The line between investment and trading activity is blurred. In HMRC’s own words:
“There may be cases where … it is difficult to decide whether the transaction is part of a trade. A distinction between these ‘equivocal’ transactions and the ‘unequivocal’ variety is drawn in the past cases.
“… There are no hard and fast rules as to what makes a transaction equivocal.”
The existing framework for real estate investment trusts (REITs) does shed some light on HMRC’s processes, however.
REITs are companies that own and operate income-generating property. HMRC outlines the framework in its Guidance on Real Estate Investment Trusts (GREIT). Below are some salient sections.
- GREIT04505: Up to a quarter of a REIT’s profits and a quarter of its assets may be ancillary to its main activity as a property rental business. This is known as the ‘residual business’. Residual business can include property development.
- GREIT04510: Disposals of assets related to the residual business are subject to corporation tax. Disposals of assets related to the property rental business are not.
- GREIT04050: One exception is where the REIT develops a property after acquisition and then disposes of it within three years. In this case, HMRC views the transaction as ‘residual’.
The taxation rules for individuals and companies (including REITs) are vastly different. But the ‘three-year rule’ provides insight into how HMRC treats property disposals. The rule does not mean a disposal was by way of trade: just that it is distinct from the REIT’s prime function as a property rental business.
The 25% ratio is also an interesting benchmark. If HMRC were to implement similar rules for individual investors, it might be that they would have to derive 75% of their profits from rental income in order to count as such.
It comes down to the seller’s original intention
That the REIT framework may provide a benchmark is nothing more than speculation. The current regime for distinguishing investment and trading activity relies on the purchaser’s intention on acquisition.
Generally, HMRC will look for ‘unequivocal’ proof of a trading transaction. In ‘equivocal’ cases, the seller’s motivation may be a determining factor.
To determine this, HMRC will ask a number of questions, including:
- How long has the seller owned the property?
- Did the seller rent out the property?
- Is there a connection with an existing trade?
- Did the seller originally buy the property for personal use?
- Is the sale part of a series of transactions, or a one-off?
HMRC acknowledges that several transactions may be dual motive. A seller may have bought a property both to rent, and to eventually develop and resell at a profit. In these cases, HMRC would seek to identify whether either motive was a trading motive, and to what extent it characterised the transaction.
As discussed, the vast majority of buy-to-let investments provide a mixture of capital growth and income. They could thus qualify as dual-motive transactions.
These guidelines apply for businesses. But the ambiguous nature of the new legislation could mean that the logic becomes more relevant for individuals.
Summary: Andrew Turner, Director of Commercial Trust
The absence of a cast-iron distinction between investment and trade is understandable, if frustrating. It pays to have in mind your desired tax outcome before acquiring your property, and work towards realising it.
The ambiguity of clauses 75 to 78 adds another layer of confusion. Most investors buy property in the expectation that it will increase in value. The wording is such that the majority of investors would pass the “main purpose” test and be forced to pay income tax on their sale profits.
The question is how HMRC will apply the law. Despite the insistence of Mr Gauke and other MPs, the new wording is uncertain. Hence the concerns of the Law Society and other bodies.
HMRC’s assurances are welcome. But at present, the legislation of the wording is not in line with the government’s stated intention for it. The government must revisit the Bill and reword it such that the added clauses unambiguously exclude landlords. There must also be clear and robust accompanying guidance.
A problem that has long plagued the buy-to-let sector is the government’s inability to create and apply a clear distinction between investment and trading activity. Patchwork legislation, introduced without consultation and rushed through as a Bill passes through parliament, will do nothing to help this.