Should Property 118 clients sell up?

The issue

A number of Property 118 (‘P118’) clients have received enquiries recently. These enquiries all revolve around the availability of section 162 TCGA 1992 ‘incorporation relief’ when a property business has been incorporated into a company. If this relief is available, then any capital gains that would otherwise arise can be ‘rolled over’ into the tax base cost of the shares.

Simple example

Ronald Trump owns a £20m property portfolio consisting of 40 properties which he rents out. The portfolio has £5m of mortgage debt attached to it and there is a £10m inherent capital gain. He transfers this business to a new company in exchange for that company taking on the debt and issuing 999 £1 shares (assume there was already a single £1 subscriber share). Here, section 162 incorporation relief should apply automatically and so Trump is left with company shares worth £15m (£20m less the £5m debt). However, if he ever sells the company or winds it up then he will have to use a tax base cost of £5m for the shares (calculated as £15m less the £10m rolled over gain).

The above example is fairly straightforward. However, P118 did two things in their structuring that HMRC have taken offence to:

1. P118 included a deed of trust document with an apparent drafting error. A deed of trust is something that is put in place to allow the transferor (Trump in the above example) to retain the legal title of properties but to relinquish the beneficial ownership. Although some commentators have suggested that a deed of trust itself could prove fatal to the operation of section 162 relief, this does not seem to be a point that HMRC has taken (and indeed runs counter to their guidance). They are, however, arguing that the drafting error means that the property can be returned in the future to the transferor. As a result, HMRC considers that a proper transfer of the business has not taken place and so incorporation relief is denied.
2. P118 also suggested a Capital Account Restructuring (‘CAR’) which aimed to stop business capital being locked in the company after the incorporation. Broadly, this involved a cash sum being lent to the business prior to the incorporation. The cash (from the loan) was not transferred to the company, but the loan was. After the incorporation, the business owners would lend the cash to the company to allow it to repay the loan. Through this planning, the business owners are left with a tax-free loan account with their company that they can draw down on. Although I do not think that this is necessarily offensive planning, HMRC disagree and so are refusing to offer the concession which should normally be available for business loans.

HMRC are currently using point 1 above to suggest that the P118 incorporations have been completely ineffective and so they are seeking full capital gains tax in respect of the transfer. If point 1 applies, then point 2 becomes academic because point 2 only allows HMRC to assess a portion of the capital gains tax by reference to the CAR loan. Although HMRC are also checking other aspects of P118 incorporations, the above points seem to be the key gripes. These enquiries are running on and on, and significant tax assessments are being raised against affected individuals.

Does it make sense to sell up?

A number of disgruntled P118 clients are asking whether they should just sell up. This may not be a bad idea, depending on other commercial considerations.

Example where Trump was a P118 client

In the above example, assume that Trump undertook a P118-style incorporation in March 2022, along with the alleged faulty deed of trust documentation. HMRC is asking him for £2.8m of tax (28% on £10m of gains) and interest. This is causing Trump some sleepless nights and so he wants to explore getting out of this mess by selling up.

If his company sells its portfolio for £20m then it will have no corporation tax liability. This is on the basis that the company has a tax base cost for the properties of £20m (which is the position that applies regardless of whether incorporation relief applies or not). After this sale, Trump could extract the £15m cash proceeds – after repaying the mortgages – from the company through a liquidation. Here the tax position would depend on whether HMRC win or lose their argument on incorporation relief.

If they were to win their argument then Trump would have to pay the £2.8m of tax and interest from the original transaction, although at least he would have the cash to do so. If HMRC were to lose then Trump’s £15m from the liquidation would be taxable based on a £5m base cost and so he would face a tax liability of £2.4m (24% on £10m of gains) and no interest.

WSM’s view

Anecdotally, landlords are feeling a bit down about the rental property market, irrespective of P118 headaches. Given the possibility of a large ‘dry’ tax charge looming over their heads, it may make sense to sell up. While P118 clients will still want to win their argument with HMRC, some of the pressure will be removed because they can usually bear the downside hit of losing. 

Affected clients will be waiting with bated breath for the results of a February High Court test case which will rule on whether the offending clause (above) can be rectified. If it can, then there would be considerable pressure for HMRC to back down in their enquiries and Mr Trump may be able to sleep easier …