Tag Archives: property developers

Reform of Corporation Tax Losses and Corporate Interest Restriction Regulations

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The Corporate Interest Restriction is one of two strands of the Governments modernisation of the UK tax system; with the other strand being the reform of corporation tax losses. My blog of 25 June made reference to the impact of the Corporate Interest Restriction (CIR) Regulations. Although it was mentioned in the context of both inward investment and property investment it is not restricted to those two arenas.

For many years the UK has been at the forefront of the Organisation for Economic Corporation and Development’s best practice, including measures against Base Erosion and Profit Shifting (BEPS). One of the strands of BEPS is prevention of excessive tax deductions for financing costs. Typically the financing would be intra-group with the lender being in a tax advantaged jurisdiction and therefore high levels of intra-group debt or higher interest rates would save the group tax.

CIR for groups with UK interest deduction over £2m

CIR came into force on 1 April 2017 and only has a fiscal consequence for groups whose UK interest deduction is more than £2m. £2m was taken by the UK Government as being a sum which excluded the vast majority of organisations from the legislation. If UK interest is more than £2m then there are formulaic calculations to determine the tax relief which can be claimed. Tax relief can be claimed on sums as great as 30% of EBITDA (as adjusted for tax). The Government acknowledges that this ceiling can be particularly restrictive for certain groups and therefore it is possible to apply a different ratio; one which is more dependent on external financing and UK profitability. However, this alternative strategy needs management and therefore the relevant election should not be made before medium term profit forecasts are developed.

When the interest restriction applies a group company should be appointed to notify HMRC of the group’s interest restriction and how the group wishes for that restriction to be allocated amongst the group companies. In the absence of the election HMRC can allocate the restriction pro-rata between the companies and HMRC’s allocation may not be appropriate for the group’s tax profile.

Corporation Tax Loss Relief

CIR was not the only new matter introduced on 1 April 2017. There was a revision to the fundamentals of corporation tax loss relief which became effective from the same date. Prior to 1 April 2017 unrelieved trading losses could only be carried forward and offset against future profits of the same trade. Other types of losses had their own specific restrictions.

From Spring 2017 there was a relaxation of the use of carried forward losses in a way to generate greater flexibility. However, conversely there was a restriction on the amount of the brought forward loss which could be offset in any one year. The relaxation applies to all corporates with the restriction only applying to larger, more profitable, companies. This mismatch is designed to assist the SME sector.

The relaxation allows losses to be carried forward against total profits of the same company and therefore makes them more flexible. Additionally losses can now be carried forward against subsequent profits of certain group companies, and not just the future profits of the loss making company. Before accessing this flexibility there are certain conditions to be met and those conditions cannot be assumed to be satisfied. They need to be checked.

The restriction occurs if losses exceed £5m. Prior to April 2017 brought forward losses could be offset against subsequent income without a ceiling. From 1 April 2017 the first £5m of brought forward losses can be used without restriction. However if profits of the later period are greater than £5m then only 50% of the profit above £5m can be offset by losses brought forward.

Although the Government feel that setting a restriction above £5m will remove all SMEs from the legislation I do not believe this is the case. It is common for our property development clients to have phenomenal years as sites come up for sale. If there are brought forward losses (e.g. due to the cost of financing in the period of building) then our clients cannot guarantee that all the losses are available for offset against subsequent profits. We are having regular discussions with property clients about sales forecasts and the extent that sales may occur over a number of years. Although a spread of sales is more common for residential development it may also apply to commercial sites.

1 April 2017 was a watershed for corporation tax in the UK with the introduction of both CIR and the group loss relief rules. Undoubtedly there are groups who will benefit greatly from the new rules and also groups which will experience restrictions.

The Outlook for London’s property sector

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Paul Paling of Michelmores, John Redwood of Charles Stanley with Cetin Suleyman, Goodman Jones

Uncertain times have an impact on investor confidence. With Brexit on the horizon, Goodman Jones, Michelmores, and Charles Stanley hosted a debate on what the UK commercial and domestic property market might look like over the next year.

A group of 75 owners and senior individuals within the property sector met in Michelmores’ London office to discuss whether UK commercial property is undervalued and what the future holds for the property market.

The audience responded to several interactive questions to take the pulse on the challenges and opportunities facing UK real estate.

Affordability

A third of the audience felt that affordability was the key factor likely to affect UK house prices over the next twelve months. This was followed closely by interest rates, then SDLT and tax changes, with foreign investment, at 10%, being the least likely to have an effect on prices.

Tenant Demand

An overwhelming 58% of the audience believed that tenant demand will be the main factor affecting UK commercial (non-retail) property prices over the next 12 months. Foreign investment came next with 22%, followed by 14% who felt that a change in taxation will have an impact, with only 8% of the audience viewing interest rates as a factor.

House Prices

When asked the question “Do you expect the gap in house prices between London and the South East and the rest of the country to increase over the next 5 years?”, almost 70% of the audience considered this to be either unlikely or very unlikely. A minority of 10% felt it was very likely, with 22% deeming it a possibility.

Residential best for investment

Residential was the sector that 42% of the participants felt was the best to invest in now, followed by industrial/other at 35%. Offices and retail came bottom of the poll, with 15% and 8% respectively of the audience thinking these sectors presented a valid opportunity.

John Redwood, Chief Global Strategist at Charles Stanley, then delivered a presentation which covered a global statistical overview; the general economic outlook and the main risks to the UK market. These included the impact of a US interest rate rise and whether the UK would have to follow; the tariff and trade war; the Middle Eastern crisis and Russian involvement in the balance of power; a new phase to Euro area banking and deficits troubles; a potential Chinese slowdown; and finally, the impact of President Trump on the global stage.

In relation to the UK commercial property market, Mr Redwood highlighted the trophy purchases of several iconic London landmarks. He saw these as demonstrating a trend towards falling in line with book valuations, as opposed to the situation two years ago when the Cheesegrater (122 Leadenhall) sold for 25% above book valuation. However, as the recent purchases of a combined total of over 3 million square feet of office space by Apple, Facebook, Google and Bloomberg demonstrates, the technology, media and telecoms sector is currently spearheading demand for London space.

Will this level of demand continue? Mr Redwood discussed the negative and positive influences that could affect the UK property market, and put forward three scenarios outlining: Best Case (Stronger Growth); Worst Case (New Crisis); and Base Case (Muddling Through). With a 65% probability for the Base Case the message for the audience was that, while uncertain times lie ahead, things could be considerably worse, and a patient and pragmatic approach may be the best way to weather the storm.

Paul Paling, Head of London Michelmores, commented; “The evening stimulated keen debate, and as John Redwood highlighted there are headwinds to be reckoned with, however the outlook is not doom and gloom. We believe that the UK property market will continue to be resilient and an attractive investment prospect.”

Cetin Suleyman, Managing Partner, Goodman Jones concluded, “It was fascinating to hear the views of the room which included property developers and construction business owners. John Redwood’s observation was that digital transformation will have a significantly greater impact on business success than a short-term economic impact of the Brexit deal. As ever, uncertainty brings opportunity for entrepreneurs and businesses willing to invest in evolving to line with future market expectations.”

Commercial to residential: the VAT minefield for developers

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converted residential buildings property development

Acquiring commercial sites to convert to residential use is proving an increasingly popular strategy among property developers.

There seem to be several factors driving this trend. These include good availability of vacant commercial sites, and a growing demand for residential space. In addition, commercial locations can carry permitted development rights, which ease planning restrictions for developers.

A word of warning, though: the VAT implications when converting commercial to residential is a minefield.

It’s very different to developing bare land, for example, or redeveloping an existing residential site. These arrangements rarely expose developers to the most intricate aspects of VAT.

Converting commercial to residential, however, does have some extremely complex VAT implications. It’s easy to get caught out, and the cost of doing so will hit development profits.

Let’s take a look at some of the pitfalls. And I stress ‘some’ – the list below isn’t exhaustive.

Pitfall 1: Election to waive exemption

Developers will know that commercial property begins life exempt from VAT. But owners may have waived that exemption (sometimes known as “opting to tax”) at some point during their ownership of the property.

If the vendor has taken this option on the site you’re acquiring, then 20% VAT will be added to your purchase price.

Before finalising contracts, therefore – and preferably before agreeing Heads of Terms – you need to check whether the owner has elected to waive the VAT exemption. Otherwise, you could end up with a large, unexpected VAT bill.

Pitfall 2: Reclaiming VAT

You’re probably thinking that the obvious solution to the above scenario is simply to reclaim the VAT.

In most cases, you’d be right. Though bear in mind that it takes several months, which will impact cash-flow.

But to reclaim VAT, you will of course need to be VAT registered. And that’s where the delay lies. Developers often use Special-Purpose Vehicles (SPVs) to purchase sites, which are rarely VAT-registered.

You can apply to HMRC to register an SPV for VAT, but it’s not a user-friendly process. Many applications are delayed or rejected because the case isn’t presented properly. You’ll need technical advice to help present your case, and to ensure your application is approved with minimum delay.

Also, care must be taken over the date on which you register for VAT to ensure you maximise your VAT recovery.

Pitfall 3: The SDLT premium

Stamp duty land tax (SDLT), currently set at rates of up to 5%, is charged on the gross purchase price of property. So if your vendor has elected to waive VAT exemption on the site you’re buying, this will increase your SDLT liability – whether or not you subsequently reclaim the VAT.

Pitfall 4: TOGC

There will be further complexities if the site you’re acquiring isn’t completely vacant.

Taking over tenants in a building that is already let means your purchase may come under the Transfer of Going Concern (TOGC) rules, which will have VAT implications.

The key word here is ‘may’. Whether your transaction constitutes a TOGC or not depends on several factors: the terms of the sale contract, the commercial relationships and terms of the rental contracts between the vendor and the tenants, and a host of requirements to be VAT registered and opting to tax.

TOGC sales are ignored for VAT purposes, which is obviously beneficial for developers buying sites, as it avoids pitfalls 2 and 3. But vendors may not deal with this as strictly required, and could end up charging VAT.

What’s more, any VAT paid on a TOGC in error is NOT refundable by HMRC.

Pitfall 5: Mixed use

Converting a commercial site to wholly residential use is one thing, but developing it for mixed use creates yet more complexity.

Commercial units are treated differently for VAT purposes than residential ones, which affects the VAT you can recover on any expenditure, and the amount to charge on an eventual sale. What’s more, the VAT status of the commercial space will differ depending on whether it’s sold freehold or as a long lease.

So whether you acquire a commercial site that is VAT-exempt or opted to tax, you need to consider your own strategy for waiving VAT exemption. Your decision will depend on your proposals for the site, and on the need to avoid a troublesome VAT position – for yourself and for potential buyers.

The right solution

There’s never a black-and-white solution to these scenarios. In each case, the right approach will depend on the nature of your business, the details of the site you’re acquiring, and your plans for its development.

Demand for commercial sites is high, and you’ll need to move fast to snap them up. But you must take time to consult a technical expert on the VAT implications first. Somebody who not only understands the rules, but can interpret what they mean for your business.

 

 

Offshore advantages now over for property developers operating in the UK

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PropertyDev
New rules are about to come into effect that effectively remove the tax advantages that non-UK based property developers enjoyed when developing UK property.

New legislation

Hidden away in this March’s Budget announcements was a detailed paper produced by the Government to highlight its concerns that some property developers use offshore structures to avoid UK tax “Profits from Trading in and Developing UK Land“.

Levelling the playing field

The paper describes in detail, the way in which offshore developers use these structures and how it is perceived to give them an unfair advantage over UK developers, who are liable to UK tax on their trading profits from developing property in the UK.

HMRC have for many years been challenging such structures, but the Government have proposed changes to UK tax legislation so that all profits arising from UK property development will be taxed in the UK. The new laws will take effect with the 2016 Finance Bill, but anti-avoidance rules are already in force to catch existing structures being unwound.

HMRC Task Force

As well as changes to tax legislation, a new task force is being created to identify and pursue offshore entities that do not toe the line with the new legislation.  There are rumours that some 100 structures are already under scrutiny.

Bad news for UK property developers based overseas

Clearly, those developers that operate in this way will be looking at their tax affairs and considering the additional cost that these changes will bring on them.  They’ll have to formulate a strategy to adopt the new rules and this may well lead to significant tax liabilities; something that is unlikely to have been taken into development projections that formed the basis of funding and investment appraisals.

Good news for UK based developers

However, for UK developers, this must surely be considered to be good news.  Such businesses operate in the same market place as the offshore developers, but historically have been unable to match the prices that overseas developers can pay for land given that they pay 20% corporation tax on the profits they make on each development.

Collateral damage

There will also no doubt be collateral damage.  We are likely to see legitimate overseas structures (for example, bona-fide property investors) being challenged simply by virtue of their ownership of UK property.   The aggravation factor alone will be unwelcome and the risk of HMRC challenge should mean that anyone based offshore and owning UK property would be well advised to review their position now.

In conclusion

We may find that this ultimately makes no difference to the situation as it currently stands, but my view is that it will level the playing field between UK and overseas developers as their overall post tax returns will be more closely aligned.

What remains to be seen, however, is whether this eventually puts downward pressure on residual valuations of suitable sites, which certainly over the last few years have been one of the key factors determining the shortage of supply of available land for housing.

Additional SDLT for Property Developers – What is the bottom line?

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Information is starting to filter through in relation to Wednesday’s budget announcement, and it doesn’t look good for developers of residential property.

The provisions, and the draft legislation included with them, apply an extra 3% SDLT (Stamp Duty Land Tax) to purchases of additional residential property by individuals after 1 April 2016. This was a component part of the Government’s commitment to provide more housing for first time buyers and families, announced in 2015’s Autumn statement.

What has become apparent from Wednesday’s announcements is that there is no carve-out or relief for property developers acquiring dwellings through limited companies, to develop and resell. In other words, all purchases of residential property for development by limited companies after 1 April 2016 are subject to the additional 3% SDLT.

It doesn’t need an accountant to work out the impact of an additional 3% SDLT charged on a development expecting to yield a 20% return – the developer’s profit will be reduced by some 15% – and yet these are the guys (and gals) who will build the houses needed to overcome the housing shortage. Go figure!

So I did. I pondered this in the context of the desire to build more houses, and try in some way to link that to how Wednesday’s revelations support the Government’s 5 point housing strategy?

It could lead traditional “residential to residential” developers to look to “commercial to residential” schemes? One can tie this in with the relaxation of the Permitted Development rights and conclude that perhaps the push is towards converting more office space into residential accommodation. This may favour first time buyers but is not so good for families wanting houses.

One can’t ignore Wednesday’s announcements increasing the SDLT charges on commercial property for many schemes, although in most cases it’s still likely to be less costly in terms of SDLT than residential purchases.

Or maybe one can look at more provocative ideas, which have been suggested recently. The limited information available appears to exclude the additional SDLT rates for residential property if “land” is acquired rather than dwellings.   This could potentially include back-land developments (back gardens) and brownfield sites, and that would indeed be a good thing for families looking for suitable housing.

And dare I say it, the Green Belt, would also count in this, and that is an inflammatory topic indeed!

The Finance Act 2015 – the impact on property developers

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A round up of current tax issues for property developers.

london propertyThe Finance Act 2015 may hold the record for the shortest period taken to debate a Finance Bill.  Depending who you ask the general consensus is that the debate lasted somewhere between one and three days.  This was to ensure that Parliament could be dissolved in advance of the election.  Despite the brevity of the debate there were significant changes which have an impact on the property development sector.

New 20% flat rate

Although not strictly part of the Finance Bill the new flat rate of 20% for company’s profits took effect from 1 April 2015.  This may lead to property development within a corporate vehicle more often.  The thinking being that lower tax rates lead to greater sums to reinvest or to be subject to extraction techniques.

Late Interest Rules

Property development groups of companies which receive finance from shareholders often use the late interest rules to plan for the timing of tax deductions on interest payments. This is to match the tax deduction with a period of taxable profits. It also allows companies to manage their cashflow with withholding taxes being payable in a period in which sales income can finance the withholding tax. It had been announced that these rules were to change. Finance Bill 2015 confirmed this. The impact being that the tax deductions are now more aligned to accounting accruals. For pre-existing loans there is a grandfathering period allowing a limited scope for existing planning to continue. If it is appropriate it is possible to prevent the impact of the grandfathering rules and structure affairs so that the new regime is immediately relevant to existing loans.  Either way developers should revisit their connected party structuring arrangements.

Feeder Companies

Property development SPVs are almost invariably trading entities for direct tax purposes.  This means that shareholders who are individuals can extract development profits out of the SPV tax efficiently by liquidating the SPV and applying Entrepreneurs’ Relief to the liquidation proceeds.  The extraction costs could therefore be at a tax rate of 10%.  Entrepreneurs’ Relief only applies to individuals who own at least 5% of the share capital of the SPV.  In larger developments this may preclude certain individuals, often management, from benefitting from the opportunity.  In order to overcome this, the individual would typically incorporate a feeder company in which they owned 100% of the shares.  The feeder company could own less than 5% of the shares of the SPV.  Based on the joint venture rules, as applied to Entrepreneurs’ Relief, the feeder company was deemed to be a trading company in its own right and SPV development profits could be transferred to the feeder company (free of tax) with the feeder company then being liquidated.  Entrepreneurs’ Relief would be available to the individual.

The same basics applied if the development was within a partnership with a corporate partner as a feeder company.  Development partnerships were common due to SDLT advantages which were closed in past Finance Acts.

The Finance Act 2015 has made the use of a feeder company more difficult and has restricted the ability to extract profits out of development vehicles at a 10% rate of tax. Although the changes have not closed this opportunity in its entirety the instances where Entrepreneurs’ Relief will be available has been severely reduced.  Developers should therefore be revisiting the entities they use for their trades and the investor/shareholders should revisit the entities which hold their interests in the venture.

The Terrace Hill case

Matters such as Entrepreneurs’ Relief rely on the development SPV’s being trading companies.  Sometimes it is not clear if a transaction is property trading or sale of an investment.  The Terrace Hill (Berkeley) Ltd case demonstrates this.

Terrace Hill, the development group, bought a site in Mayfair and demolished it.  An office building was build and by May 2015 fully let.  Two months later the site was sold.  Was this an investment which was sold in a short timeframe or a property development typical of the general group strategy?

It mattered to Terrace Hill as they had capital losses and the risk of a considerably penalty if they had submitted a tax return on an incorrect basis.

The tax appeal process confirmed Terrace Hills’ understanding that it was the sale of an investment.  Contemporaneous notes demonstrated this and the persons put in the witness box were felt to be credible.  The sale was not foreseen, being an unsolicited approach, which was accepted as rental income was lower than originally forecast.

The above is relevant for developers as it demonstrates the importance of contemporaneous notes, profit and cashflow forecasts, and the availability of senior staff for Revenue enquiry and meetings.

Be Wary

Bear traps which developers face include:

bear trap istock

  • Ensuring that financing structures or unconnected shareholder groupings with different profit shares may represent a collective investment scheme for financial services purposes. Specialist advice should be taken.
  • The passport treaty scheme makes negotiating the terms of debt finance from overseas parties easier. Theoretically it should also reduce the need for debate about the appropriateness of gross-up clauses within a loan document. However developers should be aware that syndicated loans can cause difficulties in obtaining a passport treaty reference number.
  • Recent case law and The Pension Regulators response has led to uncertainty about the treatment of partners in partnerships for auto-enrolment purposes. This leads to the risk that partners may be subject to mandatory pension contributions on their profit share. Care should be taken when negotiating profit shares attributable to individuals.
  • The Annual Tax on Enveloped Dwellings (ATED) is the annual tax on holding residential property within structures. The value of properties subject to this tax has fallen to those whose value is at least £1m. It will fall further to those of £500k from April 2016. There is an election out of the regime for developers with the normal deadline for election being 30 April annually. However, HMRC have recently acknowledged that the form to elect out is not available and therefore there is an extension for developers. Although this may seem a trivial matter the issue for developers is the extent that missing a deadline and therefore being charged a penalty could affect their gross status (or the status of group companies) for Construction Industry Scheme purposes.

Property developers should review their set up against these new changes and the sometimes unseen impact they may have.