Make sure you have a written agreement in sale and leaseback transactions

The issue

There are various reasons why owners of freehold property will want to carve out leasehold interests. For example, this can be necessary to allow the sale of an apartment in a block of flats, or to obtain finance in respect of an apartment. Where individual freeholders are concerned, the legal advice will often involve a new company being set up to which the freehold can be transferred, following which, a leasehold can be granted back to the individual. It is not possible for the owner of a freehold property to grant a leasehold interest to themselves because of the legal concept that you cannot contract with yourself. Although such a transaction may seem commercially to be little changed from start to finish (at the start the individual owns a freehold property and at the end the individual owns a similarly valued long leasehold interest) care needs to be taken with the tax.

Example

John owns the freehold in a block of four flats and wants to start selling the flats over the next few years. He is advised by his lawyer to set up a new company (Propco) and sell the freehold to it, following which Propco will grant a 999-year lease back to John in respect of each of the four flats. Although this will meet his commercial objective of allowing him to sell the flats separately, he still needs to understand the tax position. The freehold is valued at £5m and each 999-year lease is valued at £1,249,875, meaning that the encumbered freehold is valued at £500.

The key tax points of this transaction are considered below.

SDLT

Firstly, he needs to consider the SDLT position. Commercially, this is a property exchange whereby the market value going to Propco is £5m and the market value going back to John is £4,999,500. Using normal rules Propco would pay SDLT on a market value of £5m and John would pay SDLT on a market value of £4,999,500, giving a very high SDLT exposure on this transaction. Fortunately, the key SDLT points here are as follows:

1. HMRC are prepared to accept that the value going to Propco, and on which Propco pays SDLT, is £500 if there is a clear written agreement that the freehold is being transferred to Propco in exchange for it granting the 999-year lease. In other words, they accept that the relevant value should be the value of the freehold after it has been encumbered by the lease. On this basis, Propco will not have any SDLT to pay because this would fall within the nil rate band and the 5% surcharge would not be applicable for such a low-value transfer.

2. Although HMRC still think that SDLT is payable under general principles by John (above) John can take advantage of something called sale and leaseback relief if certain conditions apply, which should be the case here. Some may argue that John should not have an SDLT liability in any event, based on the logic that he hasn’t actually acquired any property, but rather his interest has slightly decreased. Given the relief, this point should be academic.

Capital gains tax

HMRC are very clear in their guidance (which was derived from a tax case) that this kind of transaction should not be treated as two separate disposals by John and Newco but rather as one part disposal of the property. Here, the proceeds assessable on John would be £500, which would almost certainly lead to a loss once transaction costs have been taken into account (although such a loss could only be used against future gains on transactions with Propco). There are also part disposal rules for ascertaining the allowable cost of the disposal which would lead to a very small percentage of the acquisition cost being treated as deductible. Again, this treatment will only be available if there is a clear written agreement whereby the sale of the freehold is taking place in consideration of the grant of the lease.

WSM’s view

We have seen cases where these transactions proceeded without tax advice, and so a freehold was transferred to the company, and a lease was later granted without an overarching written legal agreement. In these cases, there is a high risk that HMRC would consider that the transaction would give rise to SDLT in both the hands of the individual seller and the company, and that the full market value gain could be triggered in respect of the initial disposal to the company. In various scenarios where transactions are between connected individuals, or connected individuals and their companies, we often see a somewhat cavalier attitude to the importance of tax advice. As you can see above, failure to ensure that a sale and leaseback transaction is covered by a clear legal agreement can be very costly.