Commercial property forms a vital part of the UK economy, providing places for people to work, socialise and shop. While over recent years UK tax policy has sought to temper investment in a thriving buy-to-let residential property market in an effort to curb rising prices and increase supply, the taxation of commercial real estate has experienced less significant changes.
Permitted development rights enabling offices to be converted to new homes without having to apply for planning permission were made permanent during 2016 to allow the easier conversion of offices to homes. Although such measures were aimed at increasing residential property stock, some high-profile investors ditched their schemes in favour of retaining property as commercial units. A finite supply of office space, demand for good quality workspaces and rising rents led some to reconsider their approach. That said, there are some key risks of operating in this sector, including extended periods of non-occupancy and failure to attract good quality tenants on a long-term basis.
In addition, UK tax rules in the area of commercial property are complex and the ownership structure will impact on the tax profile of commercial real estate. But first, let's take an overview of the commercial sector.
The value of the UK's commercial property stock reached a high of £871bn in 2015, according to a recent study. This represents approximately 13 per cent of the UK's total property stock. Retail property and hotels form the largest share of the UK's property sector.
Growth in value has not kept pace with residential property prices. However, since 2000, the value of the UK's commercial property stock has exceeded that of the retail prices index (RPI). Around 55 per cent of commercial property is rented, which compares favourably with residential property. The average length of leases has grown since the financial crisis of 2008. Commercial property accounts for £178bn (approximately 6 per cent) of insurance company and pension fund investments. Since the EU referendum on 23 June 2016, evidence suggests that investment in UK commercial property decreased to its lowest level in four years, with central London and Scotland worst affected. The sector is susceptible to market conditions.
A recent study estimates that investors hold in excess of £480bn-worth of commercial property, which is approximately 55 per cent of the total stock. Since 2000, the value of the UK's commercial property stock has grown by an average of 3.7 per cent each year, which is slightly higher than the growth in RPI over the corresponding period.
Who is commercial property suitable for? Those with investable capital and experience and knowledge of the UK commercial property letting market. Investors are typically seeking long-term appreciation in the value of property and may seek to reinvest income and gains in further property.
TAXATION
The choice of ownership structure will affect taxation. Companies are a popular vehicle through which to hold property as the corporate tax rate of 19 per cent is lower than income tax rates of up to 45 per cent. Extraction of profits from a company may be expensive as dividend tax rates are up to 38.1 per cent for the highest income bracket.
Stamp duty land tax (SDLT)
While the SDLT regime for residential properties has seen significant changes over recent periods, the SDLT regime on the acquisition of commercial property has remained relatively benign. From March 2016, the old 'slab' system for commercial property was replaced by a progressive rate system.
The highest rate is 5 per cent, which relates to the proportion of the value in excess of £250,000. Before March 2016, properties with a value of over £500,000 attracted a flat rate of SDLT of 4 per cent on the entire value.
There are inevitable traps for the unwary and advice should always be sought in this area.
First, SDLT is calculated on the VAT inclusive price of property. There are cases when VAT must be charged (see below) and the additional SDLT will be a real cost.
Second, SDLT does not generally apply to the acquisition of goodwill. However, where commercial property is acquired in connection with a trading business and the goodwill is intrinsically linked to the land, it too could attract SDLT. Classic examples of 'trade related property' include golf courses, public houses, hotels, care homes, cinemas and petrol filling stations.
Other issues to consider would include the acquisition of commercial premises that incorporate residential dwellings. Lower SDLT rates may apply to land that includes residential and non-residential property.
Value added tax
The sale of commercially property is generally exempt from VAT. Commercial property owners may however 'opt to tax' and charge VAT at the standard rate of 20 per cent. In doing so, all supplies made in connection with the property, including rent, would attract VAT. An owner of a commercial property rental business may opt to tax a property if he or she is to incur significant refurbishment costs and wishes to recover VAT suffered on the works. However, it would mean that VAT could also apply to the disposal of the property.
HMRC accepts this is a significant cash flow disadvantage. It is therefore possible for special rules to apply in respect of the acquisition of commercial property that's tenanted. If the transfer of a going concern (TOGC) provisions apply, the acquisition is treated as neither a supply of goods nor services and VAT should not be paid by the purchaser. There are some administrative matters that must be complied with in order for these special provisions to apply.
Issues may arise where a purchaser is in the process of acquiring a property that had been tenanted, but the scale of operations has diminished. If some units are empty this would not typically be a barrier to the application of the TOGC provisions.
The option to tax is only relevant to the opter and not to anyone else with an interest in the property. The owner of a property should also bear in mind that certain types of businesses that make exempt supplies may be unable to recover VAT.
Rental profits - Choice of holding structure
In practice, individuals typically choose to hold property personally or through a company.
Income tax
In calculating the rental profits that are subject to income tax, a deduction is generally allowed for expenses that are incurred "wholly and exclusively" for the letting business. These include rates, insurance, repairs and maintenance and the cost of loan interest on borrowings which funded the acquisition. Incidental costs associated with the raising of loan finance, for example legal and professional expenses for negotiating loans, are also allowed.
Accounting depreciation is not generally an allowable expense. A rental business may instead claim capital allowances on qualifying fixed assets, typically at a rate of 8 per cent or 18 per cent, the lower rate applying to assets in a special pool of 'integral features' such as electrical and lighting systems. A business may be able to claim a 100 per cent deduction of up to £200,000 on qualifying fixed-asset additions, under the annual investment allowance (AIA).
Rental profits are subject to income tax at a rate of up to 45 per cent.
Corporation tax
A UK company will pay corporation tax on its rental profits. The rate is currently 19 per cent and will fall to 17 per cent from 1 April 2020.
Profits are calculated under similar principles to income tax profits, although there are specific corporate tax rules regarding the deductibility of interest. Unlike individuals, there should be no restriction on mortgage interest relief, although new legislation was introduced from 1 April 2017 which may affect companies and groups with interest expense in excess of £2m.
If profits are extracted from a company for example by way of a dividend, salary or interest, a UK resident recipient will be subject to tax at the corresponding rates, of up to 45 per cent on income and savings and up to 38.1 per cent on dividends. Loans introduced by an individual may however be repaid tax-free up to the amount of the loan principal.
Third-party financers often require that property is acquired through a limited company.
Example 1 compares annual tax payable on rental profits if property is held personally or through a company.
Example 1
| Income tax on rental profits | ||
|---|---|---|
| Corporation tax versus income tax | ||
Mr Glen is anticipating acquiring a property with estimated rental profits of £250,000 a year. He has asked his accountant, Mr Bird, to compare the tax payable on an annual basis if he held the property personally or through a company. Mr Glen has other income and is an additional-rate taxpayer. If held through a company, he does not intend to extract profits by way of dividend or salary and may reinvest the income in additional property acquisitions. If Mr Glen extracted dividends from the company, tax would be payable at an effective rate of 38.1 per cent. | ||
| Property held personally | Property held through a company | |
| £ | £ | |
| Taxable profits | 250,000 | 250,000 |
| Income tax at 45 per cent | 112,500 | |
| Corporation tax at 19 per cent* | 47,500 | |
| * The rate of corporation tax will decrease to 17 per cent from 1 April 2020 | ||
Capital allowances on acquisition
When negotiating the acquisition of a property either personally or through a company, it is essential that the tax history of a property is fully researched. There may be opportunities for the purchaser to access valuable capital allowances on the fixtures acquired with commercial premises and reduce future tax bills.
Fixtures are those assets installed or otherwise fixed to the land so they become part of the property. Typical examples include lifts, electrical works and lighting systems. The opportunity for a purchaser to access capital allowances may be lost if this matter is not addressed on an acquisition.
■ If the vendor has claimed all available allowances it is generally the case that a joint election will be made regarding the value of the fixtures. This can be for any amount from £1, which may be the vendor's preference, but cannot exceed the original cost of the assets.
■ If the vendor could have claimed allowances but did not do so, the vendor is required to quantify the amount of such fixtures. If it fails to do so, allowances cannot be claimed by the purchaser. A joint election is signed to agree the value of such fixtures to avoid the requirement to apply to the tax tribunal in order to agree an apportionment.
■ If the vendor has not claimed allowances because it was not entitled (eg on 'integral features' such as electrical systems, which did not qualify before 2008) the purchaser merely needs to prepare an apportionment of its expenditure and claim this in its tax return in due course. The seller is not required to pool such costs.
Opportunities to claim capital allowances should also be available in respect of refurbishment projects and it is always recommended that detailed records of works are retained to identify qualifying costs. See Example 2.
Example 2
| Claiming capital allowances | ||||
|---|---|---|---|---|
Mrs Rock has acquired a commercial property from Mr Innis for a total price of £3,000,000. Mr Innis acquired the property when new during 2010 and Mrs Rock and Mrs Innis elect for the value of fixtures to be £250,000 (integral features). Other loose fittings such as furniture are acquired and £75,000 is paid under the purchase agreement. Following acquisition Mrs Rock arranges for large-scale improvements to the property to attract better quality tenants (see below). Capital allowances available in the year of acquisition are calculated to be £245,700 (shown in brackets below). These will be deducted against the rental profit and if Mrs Rock is a 45 per cent taxpayer will eventually be worth £110,565 to her in cash terms: | ||||
| Main pool (18 per cent) | Special pool (8 per cent) | Non-qualifying | ||
| Fixed assets acquired with property | £ | £ | £ | £ |
| Fixtures (election made to fix price) | 250,000 | 250,000 | ||
| Other furniture | 75,000 | 75,000 | ||
| Refurbishment | ||||
| Structural building works | 75,000 | 75,000 | ||
| Integral features | 15,000 | 15,000 | ||
| Other plant and machinery | 150,000 | 150,000 | ||
| Total cost of refurbishment | 565,000 | 225,000 | 265,000 | 75,000 |
| AIA (max £200,000) | (200,000) | 0 | (200,000) | 0 |
| 365,000 | 225,000 | 65,000 | 75,000 | |
| Capital allowances | (45,700) | (40,500) | (5,200) | |
| 319,300 | 184,500 | 59,800 | 75,000 | |
CAPITAL GAINS TAX
Individuals
The main rate of CGT applicable to commercial property decreased to 20 per cent from April 2016. Entrepreneur's relief (ER) - CGT at 10 per cent - is unlikely to apply unless the disposal is connected with the withdrawal by the vendor from an associated business that operates from the premises.
CGT may also be payable on the outright disposal of a property and all or part of a lease premium, the remainder being subject to income tax.
Special attention will need to be given to payments made by a landlord for a tenant to vacate premises as the cost may not always be deductible.
Companies
Companies pay Corporation Tax on disposals. If a vendor wishes to realise value, it is often more straightforward to dispose of shares.
Inheritance tax
IHT is charged at a rate of 40 per cent. Investors should be aware that business property relief (BPR) is not generally available on assets or shares of a property rental business. A number of significant tax cases have also decided that businesses such as serviced offices, industrial parks and some caravan sites may not qualify for BPR. Should a beneficial owner die while owning UK property in their own name, a charge to UK IHT will arise based on the value of their share of the property on death, in excess of the nil-rate band (currently £325,000).
A loan outstanding at the date of death may, however, reduce the value of the property for IHT purposes provided the loan is structured correctly.
Another option is to make lifetime gifts of interests in the property to children or into a family trust. In the case of a family trust, CGT should not be payable on the gift provided the donor, his wife and minor children are excluded from benefit. The donor must always survive seven years for the gift to be effective.
Life insurance cover can also be a useful tool to mitigate IHT exposure, by ensuring that families will have the necessary funds available to pay any IHT liabilities.
OWNERSHIP THROUGH OTHER VEHICLES
Non-resident company
This may be appropriate for non-resident individuals. HMRC is currently consulting on whether offshore property investment companies, which are subject to income tax, should be brought within the charge to UK corporation tax.
Pension schemes
Rental income and gains made within a pension scheme such as a self-invested personal pension (Sipp) should be tax-free.
There is a lifetime allowance of £1m and investors should beware of breaching this limit as a tax charge of 55 per cent may be applied to any excess of the fund used to take benefits.
It is also important that pension schemes buying a property review its capital allowance history, so that these details can be passed to a future purchaser.
Summary
The commercial property sector does offer an investor some opportunities to secure income streams. If good quality 'blue-chip' tenants with very little management can be sourced, commercial real estate can be an attractive sector in which to invest. Evidence indicates that lease lengths have increased since the lows reported during the aftermath of the 2008 financial crisis.
As demonstrated, the choice of acquisition vehicle will make a difference to the tax profile of the investment. If uncertain, it is advisable that investors model the potential cash flows that will derive from each holding strategy. Other matters should also be agreed between the parties, including the price payable for fixtures, as access to capital allowances can be offset against future rents.
Helena Kanczula, Corporate Tax Director and Stefanie Stapleton, Private Client Manager, Blick Rothenberg
