Lucy Mangan – Partner
From April 2016 anti-avoidance rules came into effect which could restrict Entrepreneur’s Relief (ER) being available on capital distributions on the winding-up of a company. Therefore, property developers are at risk of being caught out if careful planning is not considered.
Why is this important?
If applicable, ER would allow the capital gain arising to be taxed at a rate of 10% and the new rules result in tax being paid at the dividend rate up to 38.1%. A potential increase of 28.1% is not a small amount!
When do the new Entrepreneur Relief rules apply?
The new rules are complex and advice should be sought for individual circumstances but essentially they are aimed at situations where:
- Individuals wind up a company and within 2 years carry on a similar trade or activity either directly or through another company, AND,
- It is ‘reasonable to assume’ that obtaining an income tax advantage was the main or one of the main purposes for winding up the original company.
Therefore, there is a factual and subjective element to the test.
What could this mean for property developers?
Property developers commonly structure each development project as a separate company, an SPV. On completion and sale of the development, the company is liquidated and the proceeds distributed to the shareholders.
Under this structure the company pays corporation tax on the profit arising on the development (currently at 20%) and the shareholders receive a capital distribution which hopefully qualifies for ER and therefore is subject to 10% tax. Overall, an effective tax rate of 28% (possibly reducing to 24.5% if the corporate tax rate reduces to 15%).
Compare this to the tax rate of up to 47% if the development is carried on directly by an individual or, through a partnership or even 50.5% if the profits in the company were instead paid out as a dividend.
Don’t panic but take care
The new rules do create uncertainty for property developers, but we don’t believe that this should cause any panic. In fact existing rules already apply which provide HMRC with the same powers to challenge the capital treatment.
One off property developers do not need to worry but continuing property developers should review the rules and how they may apply to their activities.
Who HMRC targets is hard to tell but it would appear that the targets are serial liquidators, where HMRC believe that a phoenixing process is taking place, i.e. a trading business is liquidated and then a very similar business is set up by the same shareholder.
Of course this could apply to property developers but both aspects of the test must be met for the rules to apply. Property developments are not largely set up in SPV’s mainly to reduce tax but for strong commercial reasons such as:
- They may instigate new projects with different sets of investors, thus requiring a new vehicle to carry out a particular project
- Banks often require a separate clean vehicle to finance a particular project
- The commercial risk can be segregated better in a company and separately from other projects
- A liquidation at the end of the project provides finality and a commercial certainty
Our advice – documentation is key
Developers should clearly document the reasons why property developments are carried out in an SPV, for example in board minutes so commercial intentions are precisely set out from the start. This is the best defence against the subjective part of the test in the new rules.
Things to consider
ER can still be available to property developers. If HMRC had wanted to completely remove this benefit for developers they could just have included a carve out in the ER rules for property related activities.
But take care
It is now more important than ever that developers consider and document the reasoning behind the structure of their developments to avoid falling into a unintentional pitfall.
And seek advice in advance
All aspects of ER and the structure to be used should be reviewed in advance.
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