Since late 2023, HMRC has argued that financing the withdrawal of a positive capital account balance prior to incorporation of a business is a notifiable tax avoidance scheme under DOTAS legislation.
From our perspective, this makes no sense because that practice is supported by highly regarded industry textbook guidance published by Lexis Nexis, which says as follows …
Simon’s Taxes B9:114 – refinancing and ESC D32 considerations
If there is a substantial capital account in the unincorporated business, the business owner(s) should be advised to draw this down before incorporation, otherwise that capital will be locked into the value of the shares.
More importantly, HMRC’s own manual BIM45700 clearly states:
A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business. There will, though, be an interest restriction if the proprietor’s capital account becomes overdrawn, see BIM45705 onwards.
Source: https://www.gov.uk/hmrc-internal-manuals/business-income-manual/bim45700
HMRC has also recently taken the currently unpublished view (discovered via an FOI request) that if a company takes on new mortgages and uses those funds to redeem existing pre-incorporation mortgage liabilities, such funds could be treated as taxable consideration under CGT rules.
Important context: Property118 is not currently recommending Section 162 incorporation for landlords with mortgages while legal uncertainty remains over the treatment of mortgage liabilities. Read our current position here: Why Property118 is not currently recommending s162 incorporation to landlords with mortgages
The reason for our current position is not that the underlying principles are wrong, but that HMRC’s current interpretation conflicts with its own published guidance.
The above is intended to serve as a warning not only to landlords, but also to accountants, solicitors, barristers, mortgage brokers, lenders and financial advisers.
What our critics say
Some influencers have suggested that the timing of the financing of capital withdrawn, being so close to the date of incorporation, is abusive. We disagree on the basis that there is no evidence supported by legislation or HMRC manuals to support this stance, hence taking the case to the FTT.
They also argue that using the funds to loan to the company, immediately post-incorporation, and for the company to repay the debt quickly, is also abusive. Again, we disagree based on the same principles.
Finally, our critics have suggested that transferring only beneficial interest at incorporation is also abusive and constitutes a breach of mortgage terms, and that mortgage novation is the only acceptable method. Again, we disagree on the basis that it is common knowledge that taxation follows beneficial interest and that the Law of Property Act 1925 protects the interests of mortgage lenders even if liabilities are indemnified without the lender’s consent or knowledge. Furthermore, novation has not been mentioned in the relevant HMRC manuals since the phrase indemnity was introduced into them over 50 years ago, and in any event, very few, if any, mortgage lenders now offer novation.
Tribunal outcome
We expect the First-tier tribunal to make a ruling later this year, but the losing side could then appeal to the Upper Tribunal and beyond, resulting in the wait for much need clarity potentially being pushed back even further. Meanwhile, these matters continue to frustrate landlords who would like to incorporate their businesses for the reasons explained in HMRC’s GAAR Guidance Part D paragraph 2.2, as follows …
GAAR guidance – D2.2 intended legislative choice
D2.2
D2.2.1 This covers, for example, giving assets to children to reduce future Inheritance Tax liabilities, sacrificing salary in return for enhanced pension rights, disclaiming capital allowances to preserve reliefs for a later period, deciding to incorporate a business or to sell shares rather than assets (in both cases so as to pay less tax or Stamp Duty Land Tax) and choosing to borrow to invest in buy to let rather than using surplus cash or having a bigger mortgage on your main residence.
D2.2.2 These are all clearly things that are recognised by the statute: Parliament has given taxpayers a choice as to the course of action to take. This category might also include reorganising a trust or corporate structure in a straightforward way to fit in with a new tax regime.
The commercial reasons landlords choose to incorporate their rental property business were also documented in a report published by the Office of Tax Simplification in November 2022.
Source: https://www.gov.uk/government/publications/ots-review-of-residential-property-income
A conversation worth having?
If you are weighing up your own strategy, whether that’s to sell, expand, or restructure to improve profitability, it is worth having a discussion with a Property118 consultant to take a closer look at how your portfolio is structured as a whole now, and to forecast the outcomes based on multiple scenarios.
These conversations are typically most useful for landlords with established portfolios and relatively modest borrowing who are beginning to reflect on how their assets could work more effectively in the years ahead.
Enquire about a free initial discussion with a Property118 consultant
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