In the July issue of Rural Business, we considered the possible changes to inheritance tax (IHT) following The Office of Tax Simplification’s (OTS) report on its simplification. In this article we look more closely at the proposal to align the Business Property Relief (BPR) trading test with the current capital gains tax (CGT) tests for gift holdover and Entrepreneurs’ Relief, and consider what options are available to businesses to bring them in line with these proposals.
Currently, for a business to qualify for BPR, the business must not consist wholly or mainly of holding investments. While “wholly or mainly” is not defined in the legislation, it is commonly seen as a ‘greater than 50%’ test. Where mixed activities are carried out, it is possible for the whole business to qualify for BPR provided that the investment activity is not the main part.
The ‘greater than 50% test’ is very different to the current CGT position when some business assets are given away or sold to a third party and gift holdover or Entrepreneurs’ Relief applies. For these reliefs, the test for eligibility can be whether there is “substantial” trading activity in the business. Guidance from HM Revenue & Customs (HMRC) suggests that this will generally involve an 80:20 split of trading v investment.
The OTS proposals suggest aligning the trading test for BPR with that for gift holdover and Entrepreneurs’ Relief; thereby shifting from a 50% test to an 80:20 trading v investment test. It should be noted that this test for CGT only applies in relation to companies and therefore, if these proposals are enacted, there will still be a mismatch between CGT and IHT for unincorporated entities.
Businesses that currently would not qualify for BPR if the proposal goes ahead may wish to consider what action they can take to increase their trading activities. It is not possible to consider all the potential scenarios in this article, instead we identify some of the common issues that may arise using an example of a partnership that runs an in-hand farming business as well as owning a number of let cottages and commercial premises.
Assuming the partnership currently qualifies for BPR, on the basis that its current split of trading to investment activity is 60:40, it will be necessary to transfer a sufficient proportion of investment properties out of the partnership to meet a new 80:20 test. Some of the issues that will need to be considered are set out below.
The simplest solution would be for the partners to transfer sufficient investments out of the partnership so that they hold those assets personally. However, if there is no real change, HMRC could question the authenticity of the transfer and seek to deny relief on the basis the investments are still really partnership assets. Care will be needed to ensure there is a clear demarcation from the current partnership business.
Another partnership would be a possibility, but it would need to include different partners to that of the existing partnership. A solution might be to bring in spouses or adult children to potentially utilise any lower tax rates available. Alternatively, a corporate structure may be more appropriate, particularly where the income can be retained in the company tax efficiently, or the partner wishes to bring in other shareholders.
If the partner wanted to maintain some control over those assets but didn’t require the income or capital, a trust for the next generation may be considered, although care is needed when setting up trusts where beneficiaries include minor children.
Tax consequences on transfer
If the investment property is transferred to the person who contributed the asset to the partnership, there is usually no CGT cost, provided the partnership capital accounts have been structured properly.
Where assets are transferred to a connected entity or person, this is generally treated as a disposal at market value for CGT purposes. Therefore, a transfer could give rise to a significant CGT liability, particularly where the properties have been held for some time and so have a low base cost.
Relief may be available to defer the gain, but these usually apply in very specific circumstances and therefore care will be required to ensure the transfer is structured tax efficiently. If no relief is available there could be a tax charge with no proceeds to pay the tax.
If property is involved, Stamp Duty Land Tax (SDLT) can arise where there is consideration or deemed consideration on the transfer. Gifts do not usually give rise to an SDLT charge, as there is no consideration. However, taking on debt is a chargeable consideration for SDLT purposes; therefore, particular thought will need to be given to any investments that are currently mortgaged. One solution may be for the partners to review their borrowing arrangements in advance of any transfers.
In addition, where a partnership owns property and there is a withdrawal of capital or a change in the partnership sharing ratios within three years of land being added to the partnership, an SDLT charge can arise.
VAT is unlikely to be relevant where the assets include let residential property. However, a VAT cost could arise on transfers of commercial property if they have been opted to tax. It may be possible to avoid a VAT charge where the transfer can be made as a ‘transfer of a going concern’ (TOGC).
Any future income from investments will be taxable on the transferee.
Other considerations include:
- Are changes required to the partnership agreement to provide greater flexibility to enable future changes to partnership assets?
- If the partnership has loans, will the bank be willing for the partnership capital to be reduced without a corresponding reduction in debt?
- Will the reduced partnership income be sufficient to service any existing debt?If the investments currently subsidise the farming activities, how will the partners fund those costs going forward, if they do not retain the properties?
- Will the withdrawal of the investments have any adverse impact on suppliers or other business contracts?
We still await the government’s response to the OTS recommendations. In the current political climate and with a pending General Election, there is no clear timeframe as to when a response is likely to be received. Though it may be too early to start implementing any changes, it could be an opportune time to review a business’ current position, perhaps as part of an overall IHT planning strategy, to ensure maximum flexibility so that swift action can be taken if the recommendations develop into firmer legislative proposals.