Oct 242013

In this article we shall see how the Lease Premium Rules can be used to enable a landlord to claim a tax deduction for part of the purchase price of the property. This can be extremely useful since capital costs cannot in general be set against rental receipts.

It should be noted however, that this is not a “cure-all” – the viability of the method proposed depends on a number of factors, as we shall see below.

A recap on the Lease Premium Rules

In Part One, we saw how the grant of a short lease is taxed when a landlord charges the tenant a premium. In particular, we saw that part of the premium is treated as an income receipt, while the remainder is taxed as capital. In the absence of these rules, the whole of the premium would be taxed as capital, but the landlord would be able to offset this amount against part of the base cost of the property. The effect of the Lease Premium Rules is to deny relief for the income element, which is now treated as a payment of rent.

The other side of the coin is that the tenant can treat this deemed rental payment as a business expense1, which can be deducted against his own business receipts. Ironically, it is this feature of the Lease Premium Rules that can be used by a landlord to claim tax relief when buying the property, as we shall see below.

In the following discussion, we shall assume that the parties are corporate entities.

How is the property sale structured?

In the diagram, V is the vendor of the property. We have two “purchasers”, rather than one, and we shall call them L1 and L2, to indicate that the property is being acquired with a view to renting it out. L1 and L2 are connected parties – for example, they are members of the same corporate group.

Lease Premium Rules - premium strip

Two transactions take place:

  • V grants L1 a short lease for a premium. This premium represents a significant portion of the overall purchase price. Under the Lease Premium Rules, part of this amount will be treated as an income expense which L1 can deduct against future rentals (see below);
  • At the same time, V sells the freehold reversion to L2. Accordingly, L1 and L2 together control the property, though it has now been split in two distinct parts.

How does the landlord obtain tax relief?

Let us have a closer look at how the premium is taxed.

We shall assume that the lease is for 10 years. Recall the formula for calculating the income element of the premium:

P – [(P x Y)/50]

where P is the premium, and Y is the number of complete years that the lease is to run, less the first year2.

We can simplify this last expression to:

[P x (50 – Y)]/50]

So for a 10 year lease, Y=9, and the income element amounts to 41/50 or 82% of the premium. This is the amount available for tax relief, with the deductions being spread out over the length of the lease3. So in this case, L1 in its capacity as V’s tenant, is entitled to yearly deductions amounting to 8.2% of the premium.

It is important to note that it is L1 rather than L2 that must take on the role of the landlord when it comes to letting the property. Although L2 has the freehold, it is L1 that is deemed to have incurred the income expenditure. Furthermore, the legislation specifically states that it is the tenant of the short lease – L1 in this case – that has to carry out the property business in order for the deduction to be available.

Note that L1 is both a tenant and a landlord at the same time:

  • It is the tenant of the short lease granted by V4;
  • This gives L1 the necessary property rights to be a landlord and sublet the property.

Although the deduction arises out of a payment to V, there is no requirement that L1’s original landlord remain in this position. In other words, the deduction is not lost on account of V selling the freehold to L2.

What are the key considerations in going down this route?

There are three key issues to consider in determining whether it is worthwhile to structure the sale in this way:

  • How to allocate the purchase price between the freehold and the lease premium. Ideally, one should allocate as much as possible to the lease premium, but this should be on a reasonable basis. It is tempting to allocate £1 to the freehold, so that for a 10 year lease, 82% of the purchase price is deductible. But is £1 a realistic figure? One should also bear in mind that this lands L2 with a minimal capital gains base cost – not such a good idea when it comes to selling the property;
  • How to fix the length of the lease. A longer lease should entail a larger premium, but a longer period of time in which the income element is written down. A shorter lease gives a faster writing down rate, but the premium – and therefore the amount of the relief – is now smaller;
  • How much tax relief is available on a straightforward sale? In particular, one must ask whether there are comparable deductions available by way of capital allowances. There is little point in taking the lease premium route if a similar result can be achieved on a straightforward sale.

Further considerations – how to rent out the property

There is no denying that the way in which the property is split, is awkward. For example, what is the position if it is intended to sublet the property to a tenant T for more than 10 years, the length of L1’s headlease? T will require a full lease for 10 years and a second lease, granted at the same time as the first, but taking effect after the latter expires.

There are various options that may be considered:

  • L2 grants L1 a long lease to take effect immediately after L1’s short lease expires; alternatively:
  • L2 transfers the freehold to L1; Both these options will enable L1 to carry on being the landlord after T’s 10 year lease expires. In either case, L1 grants T the second lease. Alternatively:
  • L2 takes over the landlord role by granting the second lease.

These options need to be considered carefully. From a tax perspective one must take into account that any intra-group transactions between L1 and L2 give rise to potential degrouping issues.

Further considerations – CGT

We have already noted that the price of obtaining immediate tax relief for the property is a lower capital gains base cost. In fact, there are two base costs that we are dealing with:

  • Firstly, the base cost of the freehold will be reduced because of the way in which the purchase price has been allocated between the leasehold and the reversionary interest;
  • Secondly, the lease itself has a base cost which would, in the absence of the Lease Premium Rules, be equal to the premium. However, because an income element has been carved out of the premium, the result is a reduction in the base cost5.

Note that this is not an issue for non-resident landlords who aren’t subject to CGT6.

What about V the vendor?

We seem to have forgotten about V! And yet V is a very important party to the transaction – without the latter’s cooperation, the property cannot be split in the manner proposed. If the lease premium method is to be used, it is therefore vital that V’s tax position is not adversely affected.

This is not an issue for a seller with an exempt status, such as a pension fund or a charity. However, where V is subject to UK tax, there are complications. We shall distinguish between two situations:

  • V holds the property as an investment; and
  • V holds the property as trading stock.

What is the position if V is a property investor?

Firstly, if V is holding the property as an investment, it would normally expect to receive a capital sum on a straightforward sale. If V is UK resident, it can deduct the base cost of the property, while for a non-resident investor, the sale proceeds are tax free.

However, as we have seen in our previous article, the effect of the Lease Premium Rules is to turn part of the purchase price into an income receipt. The income element is not eligible for CGT relief – UK investors cannot use their base cost and non-UK investors now have a tax liability, where previously they would have been exempt.

If V has income losses to offset the tax charge, this may be a partial solution to the problem. However, one should bear in mind that these losses weren’t generated in order to accommodate the person buying the property!

What is the position if V is a property trader?

If V holds the property as trading stock, a straightforward sale is taxed as income, which can be relieved by any relevant trading expenses.

Structuring the sale by splitting the property into its freehold and leasehold constituents doesn’t change the character of the transaction. The property was acquired as trading stock, to be resold “quickly” at a profit. This objective is equally achieved when V grants a lease, and disposes of the freehold at the same time – the property is “off V’s hands forever”. Accordingly, the proceeds of the transaction – including the premium – remain income in nature7.

Although this is an income sum, the lease premium rules still apply in this situation8. Instead of a capital/income split, as with a property investor, we have two lots of income:

  • A rental receipt – using the same formula given above; and
  • A trading receipt – which is simply the remainder.

The rental element is specifically excluded from the trading profits so as to ensure that there is no double taxation9.

The key to whether V will be amenable to the lease premium method, is whether the conversion of part of the trading profit into rent adds to the overall tax bill. For example, are there trading expenses that would have been available to relieve the rent, before it became rent? What is the position post-conversion?

Note on capital and income distinction

When considering the tax position of V the property trader, we have seen that the sale proceeds constitute income, irrespective of how the transaction is structured. Why then, should the lease premium method be used? Surely, if the payment is always income, our landlord should be able to deduct the purchase price on a straightforward sale of the freehold?

The answer is that there is no general tax rule requiring symmetry between payer and payee. The payment is income for the property trader, because the latter acquired the property and sold it as trading stock. But for the landlord, the payment is capital because it is the intended to hold the property as an investment. This is why the landlord needs the lease premium method in order to turn part of this capital payment into a deductible income expense.

Rounding up – is it worth using the lease premium method?

As one can see from the above discussion, this method is not a panacea – otherwise everyone would be doing it!

First and foremost, before deciding to go down this route, prospective landlords should look at the capital allowance position and ask whether there are comparable deductions available on a straightforward sale. If there are, there is no point in making life complicated by departing from the conventional route.

Secondly, one needs a compliant vendor for this to work. As we have seen, a vendor holding the property as an investment can be adversely affected if a significant part of the sale proceeds is converted from capital to income. This will not be a problem however for those vendors with tax exempt status. Likewise, property dealers may be amenable to this method, provided that the rental element of the premium doesn’t add to their overall tax bill.

One final point – don’t try this on your own! Always seek the advice of your professional tax adviser first.

  1.  ITTOIA 2005 ss 61, 292; CTA 2009 ss 63, 232.
  2.  ITTOIA 2005 s 277; CTA 2009 s 217.
  3.  ITTOIA 2005 ss 291, 292; CTA 2009 ss 231, 232.
  4.  This is the taxed lease referred to in the legislation at ITTOIA 2005 s 291(1) and CTA 2009 s 231(1).
  5.  TCGA 1992 s 39(1). Because the lease is a short lease, this figure is subject to further reduction under the rules for wasting assets under TCGA 1992 Schedule 8, paragraph 1.
  6.  TCGA 1992 s 2(1).
  7.  Although the grant of a lease for a premium constitutes a part disposal for CGT purposes, the legislation doesn’t actually specify that the premium is to be treated as a capital sum – TCGA 1992 Schedule 8, paragraph 2(1) – see the definition of premium at paragraph 10(2). The question whether it is income or capital is determined on general tax principles. In the case of a property trader, if the premium is characterised and taxed as income, the capital gains legislation doesn’t apply – TCGA 1992 s 37.
  8.  ITTOIA 2005 s 277; CTA 2009 s 217 – from the wording of the legislation, all that is required is that a premium is paid. It doesn’t matter whether this is capital or income – see the definition of premium at ITTOIA 2005 s 307(1), (2); CTA 2009 s 247(1), (2).
  9.  ITTOIA 2005 s 158; CTA 2009 s 136.
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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