Case study: incorporation of an unincorporated property business

case-study-property-300x180Senior Partner’s (b)log – Star-Date 27 February 2013

Hello again, dear reader.  I have neglected you, for which I apologise.  I have been persuaded to return to print to reveal some of the interesting matters that have been occupying my time of late.  Here is an interesting case with a couple of twists on a frequently occurring matter – the incorporation of an unincorporated business.

A business trades as an LLP – very profitably; its profits are some £500k per annum, shared equally between the two members of the LLP, a husband and wife couple.  The LLP trades from various premises largely owned jointly by the husband and wife and this property business has been registered by them with HMRC as a property partnership.  The property partnership generates net rents of some £500k per annum.  This is all very splendid, but is hardly tax-efficient.  The whole of the profits are exposed to income tax and the trading profits are also exposed to Class 4 NICs.  Thus, there is a huge exposure to tax and NICs at 52%!

The obvious solution is two incorporations, using different technical strategies to maximise tax efficiency.  The trading LLP is straightforward enough; its business, including all assets and liabilities, can be sold to a new company (“NewCo 1”) for market value.  The timing is crucial for two reasons:-

(a) The income tax cessation rules need to be managed.  The business has a 30 April year end, so if it ceases before 6 April, the tax charge for 2012/13 will be based on 23 months’ of (high) profits, less a deduction for overlap relief, which will be insignificant, as it is based on much earlier (and lower) profits.  As such, a cessation in 2012/13 will cause a huge amount of income to be taxed at 52%.  However, if the incorporation is delayed until the 2013/14 tax year, the income arising will be spread over two tax years, with a consequential reduction to the amount of tax due.

(b) The sale of the LLP’s goodwill will trigger a liability to CGT, albeit only at 10%.  If that disposal takes place on or after 6 April, the tax will not be payable until 31 January 2015, whereas a disposal prior to 6 April will cause the CGT to be payable one year earlier on 31 January 2014.

Going forward, the profits of the business will be taxed at the corporation tax rate of roughly 20% (with no NICs) and the profits can be extracted by drawing down on the loan accounts created in respect of the sale of the business.  As HMRC may argue about the goodwill value, it will be sensible to have a price adjuster clause in the business sale agreement so that the price payable by NewCo 1 can be adjusted to reflect the value eventually agreed with HMRC.  Then, the tax treatment will precisely match the amount receivable and the value agreed.  NewCo will have to register for PAYE and VAT and all contractual relationships (including those with the employees) will have to be transferred from the LLP to NewCo 1.  However, the tax savings will make the commercial irritations worthwhile.

The property partnership is a slightly different kettle of fish.  The properties are heavily pregnant with gain and there is no desire to trigger CGT in respect of these gains.  However, there is a desire to “wash-away” existing gains and draw out certain built-up reserves.  The way forward is to incorporate the business for shares in a second new company (“NewCo 2”), so as to take advantage of a specific CGT relief known as section 162.  The trouble with section 162 relief is that the value of the business is capitalised in NewCo 2.  The consideration for the sale of the business must be shares in NewCo 2, which is disadvantageous if there are accumulated profits or other reserves.  The solution is to gear-up the business before incorporation, so that all such reserves are extracted and the net value of the business is reduced to the CGT base cost of the properties.  A sympathetic banker is needed in this regard!

Having suitably geared-up the business, it can be transferred to NewCo 2 in consideration for an issue of shares to the partners.  NewCo 2 will have to negotiate with its bankers to take over the property business’s loans; even though this is technically further consideration, a specific HMRC extra-statutory concession allows this to be ignored for the purposes of section 162 relief.  If they wish, the former partners could then reintroduce the amounts drawn-down by them as loan capital to NewCo 2, which could then repay the bank.  The amounts so reintroduced would become directors’ loans, which could be drawn from NewCo 2 tax-free, as and when funds allowed.

The feature of section 162 relief is that the properties cease to be pregnant with gain; NewCo 2 will be deemed to have acquired them for their current market values.  The shares in NewCo 2 will be pregnant with gain, but it is unlikely that the shares will be disposed of.  As such, if NewCo 2 wanted to sell a property, it could do so tax-free – a very attractive side-effect of the incorporation process.

It is odd that whilst there is a specific CGT incorporation relief – section 162, there is no specific incorporation relief for stamp duty land tax (“SDLT”) purposes.  Indeed, the position is quite the opposite, in that there is a specific market value rule if a company acquires land or property assets from a connected party.  However, the apparent SDLT disaster can be averted because of strange computational rules concerning transfers of land and property assets to and from partnerships.  In such cases, the chargeable consideration for SDLT purposes is abated by a percentage and the abatement can be as much as 100%.  As a result, no SDLT at all is payable in this instance and it is not even necessary to file an SDLT return.  Good news indeed.

Finally, what of inheritance tax (“IHT”)?  The shares in NewCo 1 will be fully relieved from IHT because of the availability of business property relief (“BPR”), which will be given at the 100% rate.  However, the shares in NewCo 2 will not qualify for BPR at all as NewCo 2 will be a stand-alone property investment company.  This is far from ideal, as NewCo 2 will have significant value.  Happily, the solution is straightforward; if a holding company is put above NewCo 1 and NewCo 2 by way of share exchange so that the two NewCos are sister-subsidiaries of the holding company, the shares in the holding company will qualify for 100% BPR as NewCo 2’s properties will, wholly or mainly, be occupied by NewCo1 for the purpose of its trade.

That’s all for now, loyal reader.  A further case study will be posted when I return from my pursuit of winter sunshine in the vine-yards of South Africa.

And so to bed…

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