setting up a company is beneficial for non-Uk domiciliaries with higher-value properties
An investment in UK property will be treated either as an investment transaction or a trading transaction. Take, for example, the case where a clergyman inherited a house, which he sold immediately. He was attacked by the Inland Revenue for trading in property, on the grounds he had held the property only for a short time; he had made a "quick turn" on the property. The court disagreed. He had not acquired the property with the intention of selling it, but had inherited it; he had sold it because his employment provided him with accommodation and he did not wish to maintain a second home. The point to note is that even the most innocent property transaction is vulnerable to attack as a trading transaction, which would make it taxable in the hands of a non-resident because he would be trading in rather than trading with the UK.
The tell tale signs of trading include:
• Short-term ownership.
• Development/enhancement followed by sale.
• The transaction is one of a series.
• The property is not let during ownership.
• The purchase is funded by short-term borrowing.
• The owner has an associated trade.
If the investment project will be considered trading or connected with a trade in the UK then there are two possible solutions to consider.
Resolving the trade issue: Long term
For a long-term project, such as setting up a hotel business, the classic route is to use two companies. One company is resident in the UK and conducts the hotel trade. The other company is non-resident and owns the hotel building. The first company then pays a rent to the second company, which can be offset, subject to transfer pricing rules, against the first company's UK corporation tax charge on its hotel trading profits. The second company can gear up offshore to minimise the income tax payable on its UK source rental income.
For a short-term project, such as a UK property development, the development can be undertaken by a non-resident company, which pays tax (at, say, 20% in Jersey) in its jurisdiction of residence. As long as an appropriate treaty exists between the UK and the offshore taxing jurisdiction (for example, the UK/Jersey double tax arrangement) the offshore company can avoid UK tax under the treaty.
A second offshore non-tax paying company can be set up which takes a management charge from the tax paying company to reduce the tax payable in the offshore jurisdiction. The way the Revenue would attack this arrangement is to maintain that the UK development or building site constituted a permanent establishment of the offshore company in the UK, which would take it outside of the treaty, or to invoke ICTA 1988 section 776. Great care must be taken in setting up and operating these arrangements and professional advice must always be taken, especially on how the transaction needs to be disclosed to the Revenue (if at all) to obtain the treaty relief.
If the property is being acquired (1) for at least five years (as a rule thumb), (2) in order to yield a commercial rental stream and (3) is funded by a term mortgage, then it can be fairly safely considered to be an investment. As such there will be no UK tax to pay on eventual sale, so long as the owner is non-resident. These considerations apply regardless of whether the property is owned by a non-resident individual or company. Whether to hold the property as a "naked owner" or through an offshore company depends on a number of things.
Since UK rental income does not fall within the exempt income rules, anyone in receipt of UK rental income must submit a self-assessment tax return, regardless of whether the letting agent or tenant pays the rents gross or after deduction of tax at the basic rate. If the property is owned directly then all sources of the individual's UK income must be returned. If more than one property is owned the aggregate rents could push the marginal rate of tax up to 40%. If the property is held in a company it is essentially ring fenced from a disclosure point of view and the rate is capped at the basic rate, currently 22%, no matter how high the rental income.
UK property owned directly by a non-UK-domiciled individual is subject to UK inheritance tax and UK probate. If the property is held in an offshore company, it is taken outside of the UK inheritance tax net.
While prima facie using a company is tax advantageous, there is a trade off between the costs of running the company and the potential tax savings. As a rule of thumb, there would be little advantage in using a company for properties valued at less than £350,000. An offshore company administrator working with a UK letting agent can also take a lot of the strain and risk out of the transaction, the value of which should not be underestimated.
The overall tax efficiency of a property investment usually turns upon obtaining the maximum deduction for interest and the UK has considerably relaxed the rules in this area. From 1995/1996 rents have been assessed as 'Schedule A Business Profits' and expenses are deductible to the extent that they are "wholly and exclusively" incurred in connection with the Schedule A Business. However, if a company is used then two further matters must be considered.
Firstly, the Revenue may resist interest deductions where a company was only introduced at a late stage in the transaction, when the acquisition of the property was effectively a 'done deal'. This goes back to the point made in last month's article about the company's affairs withstanding scrutiny to determine the substantial reality of its corporate form.
Secondly, a company (but not an individual or trustee) is subject to the UK's transfer pricing rules. The interest deduction is not limited to interest paid to banks and other financial institutions. It is also available for interest paid on loans made to the company by the beneficial owner(s) of the company. However, the transfer pricing rules limit the amount of interest deductible to what would be payable on an arm's length basis and this test would consider both the interest rate and the loan-to-value ratio. In order to substantiate a deduction it has been suggested that quotes be obtained from banks for loans on similar terms and conditions.
Most if not all commercial UK property investment by non-residents has been effected through offshore companies for many years and offshore practitioners have developed a high level of expertise in effecting all aspects of such transactions, including such matters as capital allowances claims. For higher value properties or a portfolio of properties, the use of a company should be considered, but only for long-term expatriates, foreign nationals and for long-term investment.
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Reporting to Steve Hill
Appointed on 19 September