Stephen Herring: Taxation of Property – A Retrospective on the Coalition Government’s First Budget
October 31, 2010
Tax Partner, BDO
More than three months have passed since the Coalition Government announced their Emergency Budget but, at the date of writing, only the first of the two Finance Bills has been enacted.
Nevertheless, and now that the dust has begun to settle, we can take a closer look at the various tax measures and their impact on real estate investors. We have focussed upon the individual investor who is UK tax resident but might be either UK domiciled or has an agreed overseas tax domicile.
For those unfamiliar with the taxation of real estate, investors are broadly subject to tax on both their rental profits and on any capital gains upon the disposal of property. Taxable rental profits are calculated after the deduction of certain expenditure such as repair costs or interest on loans to acquire the property, and are subject to tax at the normal rates of income tax, which from April this year apply at rates up to 50%. Where investors hold properties in companies both their rental profits and capital gains are subject to Corporation Tax and the investor would also be subject to tax on any distributions from the company.
Capital Gains Tax
One headline grabbing change was, of course, the increase in Capital Gains Tax for higher rate taxpayers from a relatively favourable fixed 18% rate to a rate of 28%. There was an audible collective sigh of relief from real estate investors as this increase was actually lower than many pundits had feared, aggravating uncertainties for investors holding assets at significant gains who were concerned that Capital Gains Tax would be brought into line with Income Tax rates.
The Capital Gains Tax rate of 28% is unlikely, of itself, to discourage investment in real estate, given it has only been three years since ‘higher rate’ taxpayers were suffering tax of up to 40% on capital gains on most commercial investment property and almost all residential investment property.
There was some good news for those investing in real estate via corporate structures as the main rate of Corporation Tax rate is to be cut in 2011 by 1% to 27%, and by a promised – but not yet enacted – further 1% annually for the next three years, taking the rate down to 24% by 2014. This tax reduction, coupled with the 50% top rate of Income Tax, may encourage some real estate investors to use corporate vehicles to accumulate capital value in a lower tax environment. The ultimate exit may well be via a sale of the shares to realise a capital gain.
Unsurprisingly, an investor suffers a different effective level of taxation dependent upon whether their property portfolio is owned personally or in a company. Assuming an investor is subject to the highest rate of 50% income tax, and holds property within a company, the investor would be subject to tax on dividends from that company at an effective rate of 36.11% with an overall effective rate of tax on the rental profits of between 49.5% and 54%, dependant on the company’s level of profits.
On first impressions one might wonder why an investor might wish to use a company if there is at best little difference in the effective tax rate and at worse more tax to pay. The reason is largely the ability to accrue profits in the company and, say, pay back bank debt or purchase further property, without the Income Tax charge which would arise upon the Investor personally if the profits were extracted by way of remuneration or dividend. The investor might of course be able to sell the shares in the company and benefit from the more favourable 28% rate of Capital Gains Tax and also allow any purchaser to pay 0.5% stamp duty on the shares rather than up to 5% Stamp Duty Land Tax (4% on commercial property) on a direct property purchase.
The reduction in Corporation Tax rates will, in part, be funded by a reduction in rates of writing-down allowances for plant, machinery and fixtures, which will take effect from 1 April 2012 for corporation tax
purposes (and 6 April 2012 for income tax purposes). The rate of writing down allowance for both the main and so-called special rate pools will fall by 2% to 18% and 8% respectively.
Unsurprisingly, commercial real estate normally contains far higher levels of plant, machinery and fixtures qualifying for capital allowances than would typically be found in residential properties, although, investors in residential property should not forget the often advantageous route of claiming “wear and tear” allowance. This allowance permits investors to claim tax relief equal to 10% of their ‘net rent’ from furnished lettings. The ‘net rent’ is calculated by deducting any costs incurred that would normally be borne by a tenant (for example, council tax, water and sewerage rates etc).
It was also announced in the Emergency Budget that the Annual Investment Allowance (‘AIA’) is to be reduced in 2012 from the current £100,000 to £25,000. The AIA broadly allows full relief to be claimed, up to a certain limit, for expenditure on qualifying plant, machinery and fixtures. However, this change is unlikely to be of particular concern to many residential “buy-to-let” investors who, unless they hold a substantial portfolio of residential properties, are unlikely to be spending more than the new limit per annum on qualifying fixtures.
Since the introduction of SDLT in 2003, taxpayers have sought the services of specialist tax advisers to take advantage of perceived legislative loopholes to avoid paying this highly unpopular tax. Inevitably, almost every Budget since has introduced more focussed anti-avoidance measures to thwart such tax planning. The Emergency Budget was no different, and the Government announced that it intended to examine whether further changes to the SDLT rules on ‘high value’ property transactions were needed to prevent avoidance. Investors looking at these pre-packaged schemes should expect increasingly close HMRC attention and aggressive challenges.
It is not known whether there will be more details announced alongside the Chancellor’s Autumn Statement expected in November or, more likely, we will have to wait until the 2011 Budget to discover the Chancellor’s plans to negate aggressive SDLT planning arrangements across the commercial and residential property sectors.
Introduction of Residential UK-REITs
One noticeable and very disappointing omission from the Emergency Budget was a reform of the UK REIT regime rules to encourage their investment in residential property. Unfortunately, to date, even though most of the UK’s major listed commercial property companies have joined the UK-REIT regime, there has been only very peripheral residential investment within their portfolios and there is no specialist residential UK-REIT.
Generally, when UK investors buy shares in property companies they face the same ‘double taxation’, as mentioned above, whereby companies pay Corporation Tax on their rental profits and capital gains, then the individual shareholder pays tax again on their dividend income or any capital gains. Within a UK-REIT, by contrast, rental income and profits from the sale of assets are free of tax, on condition that the UK-REIT distributes most of its earnings to its investors in the form of dividends. This privileged tax status means that UK-REITs are, in effect, quoted companies that don’t have to pay corporation tax.
HM Revenue & Customs has recognised that there is an issue and has recently made various comments about this in its Consultation Document “Investment in the UK Private Rented Sector” (February 2010) including posing questions such as “What are the key barriers to investment in residential property through UKREITs, and what changes would be needed to address them?”.
It was hoped that the Coalition Government might take the opportunity to make changes to the rules to encourage residential UK-REITs which, we consider, would be very helpful to the London economy (e.g. there is substantial residential UK-REIT rented accommodation available in both New York and Sydney). One approach might have been to relax, for residential UK-REITs, the current requirement that all UK-REITs be listed on a recognised stock exchange.
This has unquestionably been a barrier.
Indeed there is arguably a good reason to remove a listing requirement for commercial property as well.
Another beneficial change, (and one already acknowledged by HMRC in their Consultation Document) is the possibility of SDLT being calculated on bulk purchases of residential property on an individual property basis thereby allowing the lower rates that apply below £500,000 to be used.
If permitted for qualifying UK-REITs this would both boost the UK private rented sector and residential UK-REITs.
We are expecting a significant number of Consultative Documents to be issued later this year by HMRC, a number of which will impact upon the taxation of real estate but, perhaps thankfully, the previous Government’s Pre-Budget Reports have been abandoned as it was perceived that they had merely become a second Budget. Let’s hope that the additional tax revenues raised by the Coalition Government from the VAT increase and the clamp down upon artificial tax planning schemes can find their way into broadly based cuts in income tax rates, further increases in personal allowances and
further cuts in corporation tax rates as soon as the fiscal deficit can be shown to have been brought under control.