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Property investment has traditionally in the United Kingdom been an attractive investment media in the combined context of endemic inflation and economic growth. Accordingly, for those who have sufficient funds, investment properties, whether let to commercial tenants or as private residences, will usually provide good returns over the long term. A significant proportion of those who create substantial wealth in their own lifetimes do so by means of property acquisition and retention.
It is vital to appreciate however that there are no particular tax reliefs applicable to property investment holding. In particular, the rate of capital gains tax on gains from property disposals is now likely to be 28%, and on death there could be 40% inheritance tax payable on the full value of a property estate. Accordingly those who build up wealth in properties should seek early advice in order to mitigate liabilities in the long term. Although some short term planning can be helpful, well conceived strategic planning is preferable to maintain and enhance family wealth.
There is an important distinction in both tax and commercial terms between direct holding of property and the acquisition of property through an investment company. Where a property portfolio is held personally outside of a company, the possibilities for mitigating inheritance tax liability on the full value of the properties held once they pass on death are very limited. They may be left to the spouse free of inheritance tax liability, but on his or her death the inheritance tax problem will then certainly arise. Alternatively, properties may be given away in lifetime and so long as the gift is more than seven years prior to death it will be free of inheritance tax liability, but a lifetime gift is a disposal for capital gains tax purposes and any gain accrued to the date of disposal of the property will then be liable to capital gains tax. Funds will need to be found from outside the property portfolio in order to meet this.
On the other hand, if properties are acquired through an investment company, it is possible to pass on shares in the company much more tax efficiently. The main drawback with the use of a company is that gains realised within the company will be liable to corporation tax on capital gains. Following the March 2011 Budget it was announced that the current rate of corporation tax of 26% is to be progressively reduced to a top rate of 23% by April 2014. Furthermore, investment assets held by a company still attract indexation relief, by reference to the Retail Price Index, on the appropriate base cost, or the later cost of acquisition.
In addition, the same gains will be reflected in an increase in the value of the shareholdings in the company so that when these are disposed of there may be effective double liability to tax on the appreciation in value of the underlying properties. However with a family property company this drawback may be more apparent than real. Only actual disposals are liable to tax, so that long term retention attracts no tax on increasing values. Very often the company will be kept in place on a semi-permanent basis as an investment holding vehicle and there may be no intention to liquidate it or to sell it to a third party.
The reason why the use of a company can be particularly tax efficient is that the total value of all the various shareholdings in the company is quite often substantially less than the full value of the company on an asset basis. It is common for the Articles of Association of private companies to place restrictions on the transfer of shares to protect the founders of the company, or a controlling group, from the dangers of shares passing into the hands of unwelcome shareholders. The effect of these restrictions, combined with various Company Law rules on when the shareholders of the company may pass ordinary or special resolutions, means that small minority shareholdings (25% or less) are often valued at a substantial discount to full asset value. The discount will be a matter for expert negotiation with HMRC’s Shares and Assets Valuation Section but it could be as much as between 50% and 75%. Holdings between 26% and 50% of total share capital will benefit from a lower discount which may be between 25% and 50%.
It will be seen therefore that if the shareholdings can be fragmented around members of the family or family trusts, it is quite possible for them to benefit from substantial discounts on asset value for tax purposes so that much of the value in the company then escapes the capital tax system entirely. Of course achieving this fragmentation can easily incur tax charges and therefore requires detailed knowledge of the complex tax rules which can apply, together with an understanding of how a tax efficient path can be found through them. We can assist in this regard.
Forming the company
Ideally, a property portfolio would be built up from scratch within a company, with each new purchase being acquired by the company as an addition to its portfolio. Often however property investment starts in a small way with acquisitions directly by one individual, and the portfolio may then be built up gradually thereafter. It will be difficult to transfer the properties into a company after some time has elapsed without significant tax liabilities.
The transfer of properties to a company represents a disposal of them for capital gains tax purposes and so gains to date will be realised on the transfer and capital gains tax payable. Although there is a capital gains tax relief which applies to the incorporation of businesses and this is designed to prevent any capital gains tax charge arising, very commonly HMRC will take the view that property investment is outside the scope of the relief. In that event the capital gains tax charge will be incurred on transfer to the company. In addition, the transfer of properties to a company gives rise to liability to stamp duty land tax.
Because of these tax liabilities, one strategy which may be considered is for a property portfolio to be left on the death of the property owner to his or her surviving spouse who can then transfer them to a newly formed company with only stamp duty land tax then being payable. Gains on all personal assets are eliminated on death with new probate value base costs established. So a transfer to a company shortly after the properties have been inherited will not normally incur any capital gains tax liability.
Existing property companies
Those who have conducted property investment via a company over a period of years will need to consider how the shares in the company can be transmitted to other family members in the most tax efficient manner. No inheritance tax is payable on an outright gift of shares to a family member, often perhaps the next generation, so long as the donor survives the gift for seven years. The gift however is a disposal for capital gains tax purposes, but the value of it for the purposes of that tax is simply the value in their own right of the shares given away. In other words, it is not relevant that the shares form part of a controlling shareholding in the hands of the donor and so if, say, a 20% shareholding is given away, the disposal value for capital gains tax purposes will be heavily discounted from full asset value, as already described. A careful tactical valuation approach can sometimes ensure that the existing base cost is sufficient to eliminate a chargeable gain on the disposal.
This discounted minority value principle is subject to a rule which aggregates all shares given to ‘connected persons’ within a six year period by any one individual.
Where a gift of shares is made to a new lifetime trust, and there have been no prior similar gifts in the past 7 years, it is possible to be eligible to holdover relief from capital gains tax and no inheritance tax arises until the loss in the donor’s estate exceeds £325,000. The valuation and anti-avoidance rules are different for the two capital taxes so careful planning is necessary to achieve the optimum benefits.
Where a controlling shareholder in a property company is elderly, so that there may be a high risk that he or she may not survive for seven years from the date of the gift, a different inheritance tax planning technique may be advisable. This involves making a gift of a small shareholding to his or her spouse, who may subsequently choose to pass that on to the next generation. We can advise on how this procedure may be used to reduce the control shareholding to below the 50% level with a minimal potential inheritance tax liability.
Where the capital gains tax liability on a gift of shares is too large to be acceptable, an alternative strategy may be considered. This involves issuing new B share capital which effectively freezes the value of the existing ordinary shares. The new B shares will have no dividend rights to current profits but contingent rights to future enhanced profits. Rights to assets on a winding up will be similarly divided. Provided that this mechanism is properly set up, it should be possible to give away the new B shares free of any capital gains tax liability. It may be sensible for the gift of the B shares to be to one or more new family trusts, as they will have no current value but can be expected to become of significant value with the passage of time and growth in the underlying value of investments.
Such a reorganisation can be tailored to the family’s needs. For example, a bonus issue of Preference Shares with a frozen capital value but high yield could be retained by older members of the family whilst giving equity or growth shares to younger members of the family.
Another strategy which may be applied in appropriate circumstances, is for a controlling shareholding to be left by will for the benefit of the surviving spouse, but not as an outright gift but instead to be spread over a number of trusts for his or her benefit. This type of planning fragments the shareholding over the various trusts and it is possible to structure it so that the value in each trust passes to the next generation without reference to the value in the other trusts.
This memorandum has given just an indication of the many possibilities for estate planning via property investment companies. In general, much can be achieved provided that it is not left too late to take tax planning advice. Even then, it can be possible to achieve tax savings, although it may be necessary for more sophisticated strategies to be adopted. There are also a number of tax provisions which have particular relevance to closely controlled companies; these have not been detailed here but they make it all the more essential that expert advice is taken before any steps are implemented.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.