Purchasing property is not as straightforward for a business as one might assume. John Woolley and Claire Trott examine the relative merits of buying via a director, the company or pension fund…
Most successful private companies will need a property to operate from – usually commercial premises. For those profitable businesses that are looking to purchase a property, the question will inevitably arise as to how that property should be purchased. Should it be bought by the director/shareholders, the company or the pension fund? The pension fund option combines the attractions of the prospect of capital growth accruing in a highly tax-efficient fund.
HMRC has strict rules governing property investment by pension funds – for example, residential property is deemed to be taxable and borrowing is limited to 50% of the net fund assets.
Many advisers will have discussed this subject with a client over the years but, as tax and pension rules change, the implications and recommendations can vary.
In this article, we first set out some general rules on the tax and commercial implications of the three types of ownership that need to be considered. We will then look at some of these points in the context of a case study. It is important to remember that this is clearly a very subjective area and the points put forward represent the personal views of the authors.
1 General comparison of the issues that need to be considered before purchasing a commercial property
First, we look at the general advantages, disadvantages and other relevant implications of the purchase of a property (from which a close company will carry on its business) being made by the company, its director/shareholders, or a SIPP set up for the benefit of its director/ shareholders.
(i) Company purchase
- It does not disrupt or distort any existing pension investment structure in any way.
- There will be no rent to pay, only interest on any debt. The interest will be tax-relievable (as would be rent).
- VAT issues will be more easily handled within the company framework.
- At current low interest rates, using corporate cash to help fund the property purchase should produce a better investment return, in terms of rent saved, compared with interest foregone.
- The property would be available to the company as future collateral for loans (subject to any loans taken to purchase the property).
- Borrowing limits may be higher for the company as a percentage of the property value than for a pension scheme.
- Holding the property in the company removes the liquidity problems a pension scheme might face, such as on an early retirement or death of a director.
- There is no inheritance tax (IHT) downside, because the property will normally qualify for 100% business relief as it will be reflected in the value of the company shares, provided the property is used only for the purposes of the business.
- The company will be liable to corporation tax (currently 19% but reducing to 17% from 1 April 2020) on any capital gains arising from the sale of the property. There is no longer any indexation allowance on new acquisitions.
- Corporation tax on any capital gains could probably be deferred by claiming rollover relief on investment in a replacement property.
- If circumstances change, the property could be sold to the pension scheme.
- Ongoing costs are broadly the same as renting because most commercial leases are fully repairing. Ownership can give greater control of when and how repairs are carried out.
- The company might not have enough cash for outright purchase, due to the need to reserve for corporation tax. This can cause a drain on liquidity in the business and the company may need to borrow to make the purchase.
- Lenders might be reluctant to lend without some repayment of capital being made during the term of the loan, and may require a higher margin of cover between rent and interest.
- The property will be available to creditors if the company fails.
- There are potentially two layers of tax on capital gains: once in the company and once on the shareholders, albeit the shareholders may have the benefit of entrepreneurs' relief on cumulative lifetime gains of up to £10m if the company is a qualifying trading company.
- If the company has to borrow to make the purchase, it should take out life assurance cover on the lives of the director/shareholders so that the loan can be repaid on the death of any one of them.
There is no inheritance tax downside, because the property will normally qualify for 100% business relief
(ii) Purchase by director/shareholders
- The property can be retained if the company is sold in the future.
- Property can usually provide a high rental yield.
- Rent is free of National Insurance contributions (NICs), so this is an efficient means of extracting income from the company, although a full open market rent would remove any entitlement to entrepreneurs’ relief on the disposal of the property.
- Rent need not be charged at an open market rate.
- If the property were held personally, there would only be one layer of capital gains tax (CGT). On the basis that there is no residential usage, the CGT rate on gains above the annual exempt amount would be 10%, to the extent that capital gains fall within the director/shareholder’s basic rate income tax band, and 20% on any excess.
- Entrepreneurs, relief could be available if the sale of the property is an associated disposal (ie broadly the sale takes place at the same time as the disposal of the business). This could reduce the effective CGT rate to 10%, but entitlement to entrepreneurs' relief would be scaled back if any rent had been charged to the company. At the level of a full open market rent, there would be no entrepreneurs' relief available. CGT rollover relief may also be available.
- Interest on any loans related to the property purchase can only be partially offset against the rent received. From 2020/2021, no offset will be available – instead, a basic rate tax credit will be available on all interest paid.
- Borrowing limits might be higher for director/shareholders as a percentage of property value than for a pension scheme. If necessary, director/shareholders may be able to offer additional collateral, such as residential property.
- The director/shareholders may be at risk as a result of any personal borrowing to finance the purchase.
- If rent exceeds mortgage interest, the tax effects of this should be considered.
- If interest costs exceed the rent, the director/shareholders may have to increase the rent or pay the excess out of taxed income (although losses can be carried forward).
- Difficulties could arise on the death of one of the director/shareholders, or if a director/shareholder wants to sell up for any reason.
- Only a director who has a controlling interest in the company will be entitled to IHT business relief on a property that has been owned for at least two years and used wholly or mainly in the business, and then at 50%, not 100%.
- The director/shareholders may become involved personally in VAT if the property is subject to VAT.
- If borrowing is required, the director/shareholders should take out appropriate life cover to enable the loan to be repaid on death.
(iii) Purchase by a SIPP
- When the property is sold, there is no CGT liability.
- The capital growth on the property does not increase the value of a director/shareholder’s shares in the company for CGT and IHT purposes, nor does it count against a director's cumulative lifetime limit for entrepreneurs' relief.
- Future directors in the business could use their pension funds to take over ownership of the property efficiently.
- The rent paid by the company to the pension scheme reduces its corporation tax liability. The rental income is received tax-free.
- The property is generally protected against the claims of creditors.
- It may be possible to pass the property out of the pension scheme on an in-specie basis when benefits are provided, either at retirement or on death.
- Pension freedoms mean that the property could remain in the pension for generations to come.
- The property will be purchased using tax-relieved funds.
- Rental income accruing to the pension fund will not impact on the member’s Annual Allowance.
- The mortgage will be repaid from tax-free rental income.
- Insufficient liquidity could restrict the payment of retirement or death benefits
- Forced sale difficulties could arise if the pension members fall out. An appropriate agreement needs to be put in place in case one member wishes to sell.
- The maximum the pension scheme can borrow is 50% of net assets.
- The Annual Allowance limits the scope for large contributions into a pension scheme to help finance the purchase of property, although carry forward may offer some help.
- Transfers needed to help finance the purchase may require financial advice.
- The property cannot be used as collateral for future loans to the company.
- The company would always have to pay a full open market rent to the pension scheme to avoid unauthorised payment/scheme sanction charges.
- Interest payable on any loan taken by the pension scheme will not qualify for tax relief as the scheme does not pay tax.
- The scheme will have to register for VAT if the property is not VAT-exempt.
- Purchases from connected parties must be on arm's-length terms if unauthorised payment/scheme sanction charges are to be avoided.
Let’s now look at some of these points in the context of a case study.
2 Case study – Boris Jester and Terry Say
Boris (43) and Terry (41) run a company called Bots Intelligence Ltd. They provide specialist lobbying services to people in commercial practice. Both are married with young children.
They are both directors and 50% shareholders. The company has taken some time to gain traction but is now highly profitable.
Bots Intelligence Ltd operates from a small office building that it rents in Canterbury, Kent. The landlord has decided to sell the property and has offered them first option to purchase it. The purchase is likely to go through in October 2019.
At first sight, they thought that it would be appropriate for the company to buy the property, but their accountant has said that there may be other options, including a purchase by them as personal owners or via a pension fund. What should they do?
(1) The current position
There are several key financial points for them to take into account in considering the best structure for property purchase.
- Bots Intelligence Ltd is a profitable close company.
- There are pre-tax profits of £200,000 (after all costs – including payroll).
- The company has £400,000 on deposit (after payment of corporation tax and other liabilities).
- Boris and Terry enjoy a salary of £100,000 each, no dividend payments are made and they each have investment income of less than £2,000 a year.
- Pension contributions of £100 per month paid on the first of the month started four years ago. The plans are worth about £8,000 each.
- Boris and Terry want to buy the property they work from for £450,000. The question is: should the purchase be by the directors, the company or pension fund?
Probably the overriding factor in most examples of this type of case is: who has the cash available to make
Here, the cost of the property is £450,000. One of the key points is how the purchase price can be raised and this, to a degree, will depend on whether they purchase the property as individuals, inside the pension fund or as
a corporate investment.
(2) Raising finance
It is not known whether Boris and Terry have any cash available for a deposit. It seems unlikely, so there is probably a need to borrow large amounts. Alternatively, the company could distribute retained cash to them as dividend/remuneration, but this will incur a high income tax/NIC cost, as shown in the next column.
If Boris and Terry do borrow to make the purchase, from 2020/2021 interest payments will no longer be deducted against rent paid for tax purposes. Instead, a basic rate tax credit will be given. This tax change makes the individual purchase route less tax-efficient and so less attractive .
- Tax at 32.5% on dividends that take income to £150,000 (48.75% on dividend income between £100,000 and £125,000 in 2019/2020)
- Tax at 38.1% on dividends that cause income to exceed £150,000
- No NICs
- Not deductible for company
- Tax at 40% on bonus that takes income to £150,000 (60% on income between £100,000 and £125,000)
- Tax at 45% on bonus that causes income to exceed £150,000
- NICs at 13.8% (employer) and 2% (employee)
- Bonus payments (and employer NICs) tax deductible for company
(b) Pension fund
SIPPs (or a SSAS) could be considered as a vehicle to purchase the property, and SIPPs are assumed below. Although the current transfer values are low, there is scope for the company to make considerable further pension contributions.
Much will depend on the funds that the company has available.
Maximum employer contribution that can be made per member:
The total combined value of the SIPPs would be £327,600 – made up of £311,600 employer contributions and transfers of £16,000.
To make the purchase, the pension fund would need to borrow £122,400, which is within the maximum borrowing of £163,800 (50% of the net assets of the scheme), giving enough to pay legal costs and other expenses incurred in the purchase. The company would be required to pay a full open market rent to the pension fund, which would be used to repay the mortgage and any excess invested. This rent would be a business expense for the company and deductible against profits.
The company has £400,000 available after payment of corporation tax and other liabilities in 2019/2020. The company would need to borrow £50,000 to make the purchase. Interest payable would be deductible for tax purposes and would be funded out of trading profits.
(3) Conclusions on funding issues
To make a purchase, the director/shareholders would have to borrow sizeable amounts. Rental income would probably exceed interest (at the current low rates), although the amount of rent payable can be controlled. From tax year 2020/2021, only basic rate tax relief would be available on interest and excess rent would be taxable.
If interest rates increase, rent may need to be increased to fund any shortfall. The director/shareholders will no longer be able to offset interest payments against rental receipts for tax purposes and this will need to
Should the company distribute funds to the director/shareholders as a bonus/dividend to assist with the purchase, this would incur a high tax cost.
The individual purchase route does not therefore look favourable and the choice is thought to be between a purchase by the pension fund and a purchase by the company.
(4) Tax issues
On the basis that the decision is between a company purchase and purchase by a SIPP, what are the main issues involved?
As will be appreciated, this is a highly subjective and complex subject. The views expressed above are those of the authors and are put forward for consideration and discussion only.
John Woolley and Claire Trott
Technical Connection Ltd/St James’s Place