The following article was written in July 2013. Since that time, the Government has introduced various changes to the tax legislation, in order to discourage private landlords operating in the buy to let sector. These changes include higher SDLT rates on acquiring a “second home” restrictions on tax relief for borrowings and higher CGT rates on residential property.
This has led to increasing interest amongst individual landlords in the question whether it is worth incorporating. Although companies are also subject to the higher SDLT rates, they are not affected by the interest relief restrictions, and they are taxed at lower rates, both on rental profits and capital gains.
There is a special CGT relief for incorporating a business. In the context of buy to let incorporations, it is crucial that the properties are held as business assets rather than as an investment – and the two are not necessarily the same thing.
(This article can be downloaded in pdf format at Academia.edu.)
The case of Ramsay v HMRC (2013) UKUT 0226 concerned the issue whether capital gains tax relief is available on the incorporation of a property letting business. In principle, the answer is “yes it is”, but in practice, it may be quite tricky to achieve, as we shall see in this article.
The First Tier Tribunal held that the landlord, Mrs Ramsay was not entitled to the relief on the basis that she wasn’t actually operating a business. This was in spite of the fact that she was doing considerable work – even to the extent of making substantial refurbishments and applying for planning permission to redevelop the property.
The Upper Tribunal allowed Mrs Ramsay’s appeal, so this ought to be of some comfort to all the other property landlords out there who may wish to incorporate one day. However, there are few clues in this case to give helpful guidance to those in a similar situation.
So how was this case decided, and is there anything that we can learn from it?
Background – what was Mrs Ramsay doing with the property?
Mrs Ramsay, together with her brothers, inherited a large house which was divided into ten separate flats, five of which were occupied at the relevant time. She bought out her brothers and assigned part of her own share to her husband.
Subsequently they transferred their shares in the property to a company specially incorporated for the purpose of redeveloping the flats. The Ramsays had started this process by instructing surveyors and applying for planning permission. As consideration for the property transfer, the Ramsays were issued with shares in the company.
The property transfer would normally attract a CGT charge. However, if the conditions for incorporation relief apply, the tax is rolled over and deferred until such time that the shares are disposed of1.
This is what the legislation says about the scope of the relief2:
“This section shall apply for the purposes of this Act where a person who is not a company transfers to a company a business as a going concern, together with the whole assets of the business, or together with the whole of those assets other than cash, and the business is so transferred wholly or partly in exchange for shares issued by the company to the person transferring the business.”
Note what the words of the legislation say – it is a business that is required – which includes, but is not limited to a trade. So property letting can qualify, even though it isn’t a trading activity – as long as it also constitutes a business, incorporation relief should be available.
As stated previously, the lower court decided that Mrs Ramsay wasn’t in fact operating a business, in spite of the considerable time and effort she put into the property. The following are just a few of the things she was doing:
- Meeting each of the then five tenants to explain that the rent must be paid on time, and paid to the accountant who was managing the property;
- Taking responsibility for checking and paying the quarterly electricity bills for the communal areas;
- Arranging insurance policies for the property;
- Taking responsibility for confirming with the council, compliance with fire regulations and installing or replacing fire extinguishers;
- Various outdoor activities such as fencing and hedging, pruning shrubs and clearing leaves away from the property, weeding the back door garden and car park, taking unwanted rubbish dumped on the property back to the local tip;
- Cleaning up vacated flats to ensure they were fit for purpose for the incoming tenants.
Not enough to convince the First Tier Tribunal. Although she was working quite hard, she was doing no more than was necessary for maintaining or enhancing the property as an investment asset.
Mrs Ramsay decided to lodge an appeal.
What right does the Upper Tribunal have to interfere with the decision of the lower court?
Before we go on to look at why Mrs Ramsay’s appeal succeeded, it is first helpful to know the basis on which the Upper Tribunal can overturn the decisions of the lower court.
This case was an appeal to the Upper Tribunal on a question of law. Findings of primary fact made by the lower court are rarely interfered with. The court that heard the original action will have had sight of the evidence for the first time and the opportunity to hear and question witnesses – the appellate court does not have this facility, though it does have recourse to the transcript of the evidence.
However, where secondary facts are concerned, the Upper Tribunal can interfere. Secondary facts are facts made by inference from primary findings. If the lower court made an error of law in making such an inference, the decision can be overturned.
For example, an error of law has been made when:
- The primary facts do not constitute sufficient evidence to justify the secondary finding;
- The lower court has misdirected itself by asking the wrong question or applying the wrong legal test;
- The lower court has misdirected itself by looking at legal cases and legislation that have no bearing on the matter.
If an error of law has been made, the Upper Tribunal can set aside the First Tier Tribunal’s decision and either remit it to be decided again, or it may decide the matter afresh of its own accord – which is what happened here. Where it does decide the matter afresh, the Upper Tribunal is free to make its own findings of fact3.
Where did the First Tier Tribunal go wrong? What constitutes a business?
This is a question of fact, to be determined by considering the context in which the term appears in the relevant statutory provision4. In this case, the relevant provision is TCGA 1992 s 162.
Where the lower court went wrong is that they appear to have gone round the houses, looking at all sorts of places where the word “business” appears in the tax legislation except for the right one! For example:
- They started off by looking at the old ICTA 1988 Schedule 15 rules that require the rentals to be taxed as part of a property business, and then went on to consider the trading/investment distinction;
- They looked at the word “business” in the context of business property relief for inheritance tax purposes;
- A look at a national insurance case;
- And to round off, a look at a VAT case.
However, as the Upper Tribunal judge pointed out, these cases have no relevance to the issue to be determined. By looking at other parts of the tax legislation, the lower court was putting unnecessary constraints on its interpretation.
The starting point for incorporation relief is TCGA 1992 s 162 because that is the part of the tax legislation that applies to Mrs Ramsay’s situation, and it is in the context of that section that the term “business” must be interpreted. The judge held that there is nothing in that section that requires the word to be interpreted in any way other than its ordinary general every day sense.
Having held that the lower court got it wrong, the judge went on to consider the question afresh. Although this was not explicitly stated, there appear to be two hurdles to consider when determining whether property letting amounts to a business:
- Are the activities undertaken by the landlord capable of amounting to a business? This question was determined using the Lord Fisher criteria5, considered to be of general application;
- If so, one must then look at the extent of those activities. Even if the activities are capable of amounting to a business, they may be equally consistent with the property being held as an investment – so there needs to be some distinguishing characteristic.
First, what are the Lord Fisher criteria? These are the questions to ask:
- Is it a “serious undertaking earnestly pursued” or a “serious occupation”?
- Are the activities an occupation or function actively pursued with reasonable or recognisable continuity?
- Do the activities have a certain amount of substance in terms of turnover?
- Are the activities conducted in a regular manner and on sound and recognised business principles?
- Are the activities of a kind which, subject to differences of detail, are commonly made by those who seek to profit by them?
This is what the judge said about the work Mrs Ramsay was doing6:
“…overall, taking account both of the day-to-day activities, and the work undertaken by Mrs Ramsay in respect of the early refurbishment and redevelopment proposals, I conclude that the activities fall within the tests described in Lord Fisher.”
The judge also found Mrs Ramsay passed the second hurdle7:
“…the question of degree…is relevant to the equation because of the fact that 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. Although resolution of that issue will be assisted by consideration of the Lord Fisher factors, to those there must be added the degree of activity undertaken.
Applying these principles, in this case I am satisfied that the activity undertaken in respect of the Property, again taken overall, was sufficient in nature and extent to amount to a business for the purpose of s 162 TCGA. Although each of the activities could equally well have been undertaken by someone who was a mere property investor, where the degree of activity outweighs what might normally be expected to be carried out by a mere passive investor, even a diligent and conscientious one, that will in my judgment amount to a business. I find that was the case here.”
What does the case say?
The key notion coming out of this case is that the question whether a person is conducting a business is a question of fact, to be determined in the context of the legislation in which the term appears.
For the purposes of incorporation relief, the word “business” has to be given its ordinary general meaning, which is a broad meaning, uncoloured by the relevant statutory provisions. In making this determination, one looks at the totality of the activities undertaken before coming to a conclusion
But how does one make this determination in practice? It is clear from what the judge said, this is a value judgement. While one judge may think that the activities are sufficient to constitute a business, another judge may think that those activities fall short of what is required.
In Mrs Ramsay’s case, there were in total, 17 different activities listed in the judgment, and it was also noted that she instructed surveyors and applied for planning permission to redevelop the flats. She clearly wasn’t sitting idle, and yet the lower court found that she wasn’t doing enough. According to the lower court, what she was doing was equally consistent with maintaining or enhancing the property as an investment – so in order to qualify as a business, she had to do something over and above this.
Now this “over and above” requirement is actually the wrong test, as pointed out by the Upper Tribunal – it is not supported by case law. But even the Upper Tribunal went on to consider whether Mrs Ramsay was doing more than was required, in order to differentiate her position from that of a “mere investor”. The appeal judge, applying the right legal test, could equally have found that Mrs Ramsay fell short of the line.
So what can a property landlord do to ensure that incorporation relief will apply?
As stated earlier, this case gives very little guidance!
The best that can be said is that if you are renting out a property, make sure that you are as actively involved in managing it, as possible. Visit your tenants and the property regularly, ask for regular reports from your letting agent if you have one, maintain and file all the relevant documentation. In short, be businesslike.
Remember, all this has to be done from the very outset of the property venture – in other words, when starting out, you should bear in mind that one day in the future, you may decide to incorporate. This is what your adviser (if you have one) should be telling you!
Postscript – what about Richard
Who’s Richard? And why is he so important?
Richard Ramsay happens to be the Ramsays’ son. Shortly after the Ramsays incorporated the business, they gifted their shares to Richard, who became the sole director and shareholder of the company.
One question that occurs is what is the capital gains tax position on the gift?
Note that there is no CGT exemption when a person gifts assets to a son or daughter. The transaction is treated as a normal disposal made at arm’s length value, with a deemed market value consideration8. In other words, the Ramsays should have been subject to CGT on gifting the shares.
If the shares were gifted shortly after company was formed, one would not expect there to be a significant capital gain. The base cost of the shares would match the value of the property transferred into the company at the date of incorporation. One would not expect the value of the property – and therefore the value of the shares – to have increased substantially by the time the gift was made.
However, the position is made more complicated now that it has been decided that the property transfer qualified for incorporation relief.
The way in which incorporation relief works is that the gain on the property is not brought into the charge to tax, but is deducted from the base cost of the shares issued9. This gain is captured when the shares are eventually disposed of. If this disposal takes place shortly after incorporation, the base cost is now less than the market value by the amount of the rolled over gain. So CGT is payable on the gift unless there are other reliefs available.
There are two possibilities, neither of which appear to apply:
- Firstly, there is gift relief on shares under TCGA 1992 s 165 – but this is only available for shares in trading companies. Mrs Ramsay’s company is not one of these – property letting may be a business, but it isn’t a trade;
- Alternatively CGT relief is available under TCGA 1992 s 260 provided the gift is subject to inheritance tax. This seems promising, but it excludes the case where the gift is a potentially exempt transfer, as is the case here10.
The other possibility is to consider the date that the transaction occurred which was 1987. Were there tax reliefs around at that time which are not available now?
The author of this article would be grateful to anyone who can suggest a possible solution!
- TCGA 1992 s 162. ↩
- TCGA 1992 s 162(1). ↩
- Tribunals, Courts and Enforcement Act 2007 ss 11(1), 12(2), 12(4). ↩
- Lindley LJ Rolls v Miller (1884) 27 Ch D 71. ↩
- Customs and Excise Commissioners v Lord Fisher (1981) STC 238 ↩
- Paragraph 65. ↩
- Paragraph 66. ↩
- TCGA 1992 ss 17, 18, 286. ↩
- TCGA 1992 ss 162(2), 162(4). ↩
- A gift is subject to inheritance tax if the donor dies within seven years of making the gift, but escapes tax if the donor survives. This makes it a potentially exempt transfer – IHTA 1984 s 3A. ↩
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