Transactions in Land Tax Investments
Landlords are usually regarded as investors and not traders. On the other hand, developers are treated as being traders. Landlords who are individuals (or partners) pay capital gains tax on their profits; while developers pay income tax if they are individuals (or partners). Companies pay corporation tax on both.
For individuals (and partners) income tax rates are higher than capital gains tax rates. Most landlords do not incorporate their businesses although changes to the treatment of mortgage interest relief do mean that more landlords are looking to run their property rental businesses via companies.
New legislation for taxing transactions in land has caused some alarm. Special provisions for taxing "Transactions in Land" have previously been in operation to catch certain transactions so that they were subject to income tax. Explicitly they were to counter tax avoidance. They only operated where the "sole or main object" of a transaction was to make a profit. This test has now been widened out, as we shall see.
The existing provisions have now been repealed and replaced by new provisions relating to transactions in land are now contained in a Part 9A inserted into Income Tax Act 2007 (ITA 2007) by the provisions of Section 79 of the Finance Act 2016. This is part of a number of wholesale changes relating to transactions in land, mainly aimed at bringing overseas companies and non residents into the tax net when they deal in or develop land in the UK.
Similar provisions are made in relation to corporation tax but this guide focuses on the income tax elements. The key change is the introduction of a test where income tax rather than capital gains tax is levied on individuals (or partners). This test is to establish whether one of the main purposes of acquiring, holding or developing land is to make a profit or gain by disposing of or developing land (including buildings) in the UK. There is also no need now to show a tax avoidance motive.
The Government assure us that it is not their intention to change the investment status of normal buy to let investments and they say that these buy to let investors should not be affected. This is written into the official H M Customs and Revenue (HMRC) Guidance.
Income Tax v Capital Gains Tax
Historically, income tax has been levied on trading in land such as developing it or selling the land on at a profit shortly after buying it. In the case of investors, they have been taxed on their rental income or, when disposing of the property, they have been liable to pay capital gains tax on any gains where the property is sold or otherwise disposed of. The receipt of rental income is not treated as a trade for the purposes of tax legislation.
Why is the new provision possibly so important?
These changes have sparked considerable controversy with suggestions that if a buy to let property is acquired and one of the reasons for doing so is to make a profit when it is ultimately sold, then the new provisions bite. In that case, instead of having to pay income tax on this capital profit at 28%, a higher rate tax payer could be charged income tax at 40% for the higher rate tax payer (or 45% if the additional rate applies). However, HMRC Guidance does offer reassurance that this should not be the case. Nevertheless, there are still uncertainties around certain transactions and much will depend on the individual facts and circumstances in these cases.
We look in detail at the published HMRC Guidance which appears in their official manual. This explains how the new rules are to be operated by HMRC. It is important to note that individual HMRC officials cannot invoke these provisions without approval from the relevant technical team.
Importantly, however, HMRC Guidance states that it is not the purpose of these rules to alter the treatment of an activity that is clearly investment.
The Guidance very much down plays the likelihood of ordinary buy to let landlords being caught by these provisions.
Homes under the hammer
Many will be familiar with the format of television property programmes, such as "Homes under the Hammer". The buyer goes to an auction, buys a run down property, intending to renovate it, does it up, and then either rent it out or even sell it at a profit. The programme employs valuers to give sale and rental valuations before the work is done and then to give a valuation of the completed property. This kind of situation would be caught by the new legislation if the buyer says that he intends to sell the property on at a profit once the work has been done.
HMRC have told us in correspondence that as the legislation is now based on a "main purpose or one of the main purposes test" they believe that this scenario will be caught. They say that at the outset there is an indeterminate state as the tax payer who purchased the property is undecided as to whether they are going to sell or hold post development. When the property is sold later on, development would appear to fall under the "main purpose or one of the main purposes" described in the legislation. Accordingly, if a tax payer were to hold the development for investment purposes, post development it would be unlikely to fall within the scope of the legislation. However, if it was sold then it would be treated as a trading transaction and an individual tax payer would have to pay income tax on the profit.
What the legislation says in detail
There are similar provisions for companies as for individuals.
The starting point for individuals is that income tax is a tax based on revenue; whereas capital gains tax (as the name suggests) is levied on capital gains made over a period of time as and when an asset is sold.
What the new Transactions in Land provisions state (Section 517B of ITA 2007) is that the Transactions in Land provisions apply if a person realises a profit or gain from the disposal of any land in the United Kingdom and any one of four conditions apply. A person acquiring, holding or developing land potentially within these provisions.
The key provision for our purposes is condition A and this provides that the Transactions in Land provisions operate where "the main purpose or one of the main purposes of acquiring the land was to realise a profit or gain from disposing of the land." Likewise, another situation under Condition D is that they apply in the case of land which is being developed where at least one of the main purposes of developing the land was to realise a profit or gain from disposing of the land when developed.
The legislation goes onto provide that in these cases the profit or gain is to be treated for income tax purposes as profits of a trade. By bringing it into treatment as profits of trade it means that higher income tax rates are payable and lower capital gains tax rates do not operate for non corporate tax payers.
At the same time, however, any losses which arise are treated in the same way as trading losses.
There are exemptions from gains attributable to the period before any intention to develop is formed where development triggers the tax liability.
Likewise, no liability to income tax arises in respect of a gain accruing to an individual if that gain is exempt from capital gains tax under the principal private residence capital gains tax exemption (Section 517M).
Taxation of capital gains
Prior to the introduction of the current system of taxation of capital gains in 1972, trading under income tax caught not only ordinary trading profits but also one off activities which were classified as "adventures in the nature of trade". Capital gains tax was first introduced in 1965 but only for short term capital gains. Prior to that capital gains were tax free entirely. Clearly, it was therefore advantageous to argue that a transaction was of a capital rather than a revenue and therefore outside the scope of tax altogether. This became rather less important when capital gains tax was introduced. Nevertheless, there are still advantages in treating a transaction as being subject to capital gains tax because of the lower prevailing rates; more so now that mainstream capital gains tax rates have been reduced, although buy to let properties are subject to higher rates of capital gains tax in the case of individuals. For corporation tax purposes this is far less important because the same rates operate when it is a capital gain or a revenue profit.
In reality, however, the kind of transactions which will be caught as transactions in land could very much be said to be adventures in the nature of trade anyway under the old rules.
These provisions are specific to landed property but similar considerations apply in the case of shares. Is someone who buys and sells shares to be treated as a dealer therefore a trader subject to income tax or as an investor?
This question actually spills over into landed property because the new
Transactions in Land provisions also apply to the "enveloping" of properties. They do not just apply to landed property itself but also to any property deriving its value from land. They apply if one of the main purposes of acquiring any property (e.g. shares) which derives its value from the land was to realise a profit or gain from disposing of the land. Therefore, potentially someone buying and selling shares in a property company could be caught by this legislation.
Assessing the tax payer's intentions
The legislation expressly provides that purposes can change as time goes on.
The tax payer's subjective intentions are determinative ultimately.
Evidence of subjective intention will include contemporaneous documents as well as testimony from the tax payer and anyone else relevant who was involved, e.g. professional advisors.
Importantly, as much depends on the subjective intention of the tax payer, any transaction involving the purchase of a buy to let property can be a recipe for dispute and litigation with HMRC.
HMRC Guidance in detail
The guidance stresses that the transactions in land legislation must always be understood in the context that it only taxes trading profits. The intention is that profits from activities which amount to (i) a trade in land or (ii) a trade of developing land are taxed as development profits. It is not the purpose of these rules to alter the treatment of activity that is clearly investment.
The rules do not alter the treatment of or re-characterise investment activities, except where they are part of a wider trading activity. In particular, they do not apply to transactions such as buying or repairing the property for the purposes of earning rental income, or as an investment to generate rental income and enjoy capital appreciation.
When looking at what is the main purpose or one of the main purposes for acquiring or developing land this is a test of purpose, not of benefit or expectation. Generally, non-trading transactions will not be caught.
The Guidance gives an example of someone who buys land with the intention of building on part of it to retain it for their own purposes and for building on the rest of it for sale at a profit (in a manner consistent with trading activity). In this case it is clear that one of their main purposes is to make a trading profit from development and disposal. At the point of acquisition, the precise section of land to be disposed of and the costs relating to that section may not be known. In this case the profits should be calculated using the original cost of the land apportioned on what is a fair basis.
The Guidance goes onto say importantly that it may be the case that, in addition to retaining rental yield, the investor in UK property expects to benefit from capital growth over time. The preconditions for applying the transactions in land provisions may not be met in the case of a straight forward long term investment if the economic benefit arising to the owner is the result of market movement from holding that asset rather than transactions that are in the nature of trading.
HMRC say that an owner may also seek to increase the value of their property by improving the quality and security of the property's rental income by negotiating longer tenancies for example. Another option is to improve the property through something of a refurbishment in order to attract higher paying tenants. Alternatively, the sub-division of the property to attract more tenants would increase the value of the property. Rental income so far as they are concerned is often an indicator that the asset is held as an investment, although this is not inclusive. An asset held for trading purposes would also produce rental income over a relatively short period. Equally, an asset held over a longer period may for a number of reasons not produce income but could still be seen as an investment. The facts of each case will determine whether or not one of the main purposes is to make a trading profit from development and disposal.
HMRC have told us in correspondence that if an extension is built, followed by the property being held for rental purposes, they do not envisage that the legislation would apply; rather any gain would be treated as a capital gain. If the development/improvements are to enhance rental yield this would not be seen as trading. Each case will, however, depend on each individual circumstances.
The Guidance reiterates what is said in legislation namely that the intention can change over time.
The Guidance sets out some general rules.
A trader dealing with land exists where land and/or property is acquired or developed with a view to making a profit on its disposal. This is in contrast with a situation where a property is acquired for investment, but over time that property may increase in value and a profit may therefore be realised from its eventual disposal. This increase in value may arise as a result of movement in the property market or action taken by an owner to enhance the value of the property for investment purposes. To establish if an individual or company is trading, the facts of each case are key. The Guidance lists out the factors which could have an impact when considering if the business is carrying on a trade or investment in respect of land. This list is not definitive and each case would depend on its individual facts and circumstances -
- Length of time the land is owned.
- Intention at purchase date.
- Any change of intention.
- How the acquisition is funded.
- The usage of the property by the owner.
- Whether it is developed or improved (rather than repaired) before a disposal.
- Whether there is a connection with the existing trade - for example a builder buying a property to renovate and sell.
The Guidance then goes onto say that a "slice of the action" contract or similar arrangement, e.g. an overage provision on the sale, is to be regarded as trading for these purposes.
The way in which a transaction is initially financed could be very important. A short term bridging loan to cover the time a property is redeveloped for example could indicate a trade; whereas a ten year buy to let loan is more indicative of an investment.
HMRC Guidance then gives a number of examples -
A non-resident property investor purchases a property with the primary purpose of realising rental income from the land purchased. When the investor purchased the land one of the factors they considered was likely capital appreciation of the land. After letting out the property for 7 years they make some repairs and dispose of the land. This is an example of an investment not trading transaction. The main purpose of the transaction is the rental income. Whilst the long term capital appreciation could be a reasonable expectation, it is clearly not a profit from a disguised trading transaction and would not therefore meet condition A.
A non-resident property investor purchases a property with the intention of developing then selling the property. After developing the property they let it out for 6 months while they wait for the market to pick up. In this instance a main purpose of acquiring the land, was to realise a profit from disposing of the land and condition A would be met.
An individual property investor acquires an old block of flats. They rent the flats out for several years then decide to build new flats on the site. They obtain planning permission for a new development which they complete and sell.
In this example there has been a change of intention and Section 517L ITA 2007 will apply. Only the profit relating to the period after the change of intention should be taxed as a trading profit. The portion relating to the period where there was an investment intention should not be included in the tax calculation.
Please see BIM60825 for details on apportionment.
Company X purchases 100% of the share capital of company Y, which owns a UK property on investment account. Company X has the intention of realising a profit in a manner consistent with trading activity, by procuring company Y that sells the property. T
his would fall under Condition B.
In this example there has been a change of intention and Section 356OL CTA 2010 will apply. Only the profit relating to the period after the change of intention should be taxed as a trading profit. The portion relating to the period where there was an investment intention should not be included in the tax calculation.
Please see BIM60825 for details on apportionment.
An individual purchases a rundown block of flats. They intend to develop the flats into luxury apartments. After development they intend to keep 55 for rental and sell 45. In this instance a main purpose of acquiring the land was to realise a profit or gain from disposing of it so condition A would be met. The profit relating to the 45 apartments should be taxed as trading income. Where it is not possible to specifically identify costs relating to the 45 apartments just and reasonable apportionment should be used.
A non-resident property investor purchases an ageing block of offices in a prime location with the primary purpose of realising rental income from the land purchased. In order to achieve a higher rate of rent and a better quality of tenant, the investor redevelops the offices soon after the acquisition and then lets out the redeveloped offices for a period of 5 years. After such time they dispose of the land at a gain. In this instance the main purpose of the transaction is the rental income. Whilst the office block is redeveloped, the primary purpose for doing so is to improve the yield from the investment rather than realise a gain.
A non-resident property investor purchases a property with a view to realising rental income from the land purchased. At the time that the investor purchased the land it anticipated holding the property for over 5 years. In fact, after 2 years, the investor suffers a liquidity event and is forced to sell the property. The main purpose of the transaction is the rental income and the sale was motivated by a sudden unforeseen emergency. Condition A would not be met in this instance.
A non-resident property investor purchases a property with a view to realising long term capital appreciation from the land purchased. The company will have to wait a significant number of years before the lease ends, or the tenant is prepared to surrender the lease. During the time that the property is held, the rental profits are poor, perhaps due to a rent-free period or vacancy arising from unexpected occupier insolvency. The investor sells the property after 5 years for a significant profit due to a market increase in the value of the land. This is an example of an investment and not trading transaction and condition A would not be met.
A non-resident property investor purchases a property with a view to realising rental income from the land purchased. At the time that the investor purchased the land it anticipated holding the property for over 5 years. In fact, after 18 months, the investor sells the property early as a result of unforeseen circumstances. In this instance the main purpose of the transaction is the rental income and the sale was motivated by unforeseen circumstances so condition A would not be met.
HMRC Guidance puts a "gloss" on the legislation so that the tax payers activities have to be of a trading nature, or an "adventure in the nature of trade" before the legislation bites. Historically, the interpretation of trade for tax purposes has always encompassed a situation involving a one off transaction intended to make a profit so this is nothing new.
Meaning of Development
The legislation refers to "development". There is no statutory definition as such. However, HMRC Guidance gives the HMRC view. It can include simply obtaining planning permission according to them. HMRC interpret development as any change upon what the property was like at the time of purchase.
The Guidance says that when considering obtaining planning permission itself is sufficient for a main purpose to be developing UK land all the facts of the case would need to be considered. The Guidance gives two examples -
A farmer has decided to sell one of his fields, he realises it will be worth more if it has planning permission so obtains planning permission prior to sale. In this instance it is unlikely a main purpose is developing UK land.
A company carried out research and decided to purchase a plot of land as they have identified the land will be worth significantly more with planning permission. After acquisition they obtain this planning permission and sell the land. In this instance it is likely a main purpose is developing UK land.
On the face of the legislation then this tax regime could catch landlords hoping to make a profit when selling but the HMRC Guidance provides some reassurance so that if you are buying/owning a property as an investment you should still be treated as an individual (or partner) as being liable for capital gains tax not income tax when you come to sell.