Thinking of a split?

Lucy Mangan - Menzies Accountant

Lucy Mangan – Property sector specialist

Some leading developers are rethinking their business model due to tough market conditions. They are deciding to rent out several properties in their portfolio. This can prove to be an effective way of increasing margins, however, considering their long-term strategy and the most tax-efficient way to plan investments is key to maximising their profitability.

In today’s economic climate, lots of developers are struggling to sell their properties for their full value or in a timely manner, therefore many more are deciding to split their investment portfolios. Instead of making a loss, this approach means they can wait until the market picks back up, and bring in some income at the same time. Although, retaining properties can have implications on tax for developers, and discovering a long-term strategy is crucial to realise the potential of their portfolio whilst not suffering unnecessary tax costs.

Setting clear objectives

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An important first step for investors seeking to rent out a few of their properties is to agree on their ultimate objectives. For instance, are they planning on eventually selling the properties or are they hoping to rent them out for the foreseeable future?

For the purpose of accounting, when developers are renting properties out in the short-term with the view to sell them immediately, they can stay in stock. This would mean that they aren’t subject to any inherent profit on their asset. For example, a property that cost £500,000 to build, with a market value of £700,000, would have an inherent profit of £200,000. But, if they are planning to rent out the property over a longer period of time, they may need to transfer the properties out of stock and into investments in the accounts. This process effectively crystallizes the inherent £200,000 profit, of which the developer would then be liable for corporation tax (currently at 19 per cent). There may also be a VAT claw back, meaning that all or some of any input VAT recovered by the developer on the property would need to be repaid to HMRC.

Combining trading (development) activities and investment (rental) activities in the same group or company can have greater long-term implications. There are benefits from holding on to shares in trading companies for inheritance and capital gains tax such as qualifying for Entrepreneur’s Relief (ER) and Business Property Relief (BPR). If rental properties are held in stock, property developers would definitely be trading companies. However this would blur the lines and depending on the balance of activities, may well mean that valuable tax reliefs are at risk.

Developers who view rental properties as a long-term investment may decide to consider transferring these assets into a separate company, because of immediate and potentially longer-term implications. The way property interests are split raises a further question; should the new company be a subsidiary of the parent company, or a standalone entity? Both options will have advantages and disadvantages.

Looking to the long-term?

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The developer would avoid paying any stamp duty land tax (SDLT) on transfer, by transferring rental properties to a subsidiary company, as the investment and trading companies would be belonging to the same group. Also, from a VAT perspective, there shouldn’t be any input VAT clawback. Downsides though, the developer company would still crystalise the inherent profit in the property and if the subsidiary remains within the group, it wouldn’t improve the BPR or ER position.  

However, to ensure the development company was not at risk of losing BPR or ER relief but would still result in a SDLT chare arising on the market value of the property transferred, rental properties must be moved into a separate, standalone company. The tax on the crystallization of the inherent profit could be viewed as a timing difference, whereas the SDLT charge could be expensive as it is an actual cost. Depending on both the longer-term and current intentions will determine what is best.

Remember to document

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To stay in HMRC’s good books and optimize their tax position, documentary evidence should be kept at each stage of their decision-making process. Keeping a full history of directors’ minutes, which show the thought processes behind their commercial strategy, will help to support VAT claims. To support the company’s long-term objectives, searching for expert support from a professional that has experience in helping developers to combine property interests can bolster a company’s chances of achieving this.  

Splitting property interests for many developers could prove to be a wise commercial strategy, permitting them to push through tough market conditions while still bringing in revenue. The value of their portfolios can be maximised if multiple options are considered for structuring their investments and various tax implications, whatever 2020 brings.

Posted in Blog, Property & construction