Capital Account Restructuring – Capital Vs Equity?

Capital Account Restructuring – Capital Vs Equity?

by J

9:10 AM, 13th June 2022, About 2 months ago

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I’m doing my research and coming around to the idea that transferring our BTL properties into a LTD company would be very sensible.

I can see that Capital Account Restructuring using a bridging loan potentially means we may never have to pay high rate income tax again …

Your article on this subject suggests that it is only possible to extract the capital and not the equity in this manner…

1. Why?
2. Surely if I took out a conventional mortgage today there would be no such restriction?
3. For a property that you have owned for 30 years, how would you calculate the capital? Just Deposit? Any thing else?

Thank you for your help

Joe

Response from the Property118 Tax Team

Hi Joe

Thank you for giving us the opportunity to clear up your confusion in open forum, because there may well be other Property118 readers who are struggling with this concept and could benefit from your questions and our answers.

Capital in your rental property business is the difference between money you have invested and what you have taken out. For example, if you had invested say £500,000 of funds which had already been subjected to taxation, never made any losses, only ever withdrawn your taxed profits from the business and never made any losses then your capital would remain at £500,000. However, the likelihood of this ever happening in reality is quite low. There could be years when some of your profits after taxation were retained or reinvested and there may also be years when you have withdrawn more from the business than you made in profits. Events such as these will add to or take away from your £500,000 of capital. The value of your capital in the business is known as your Capital Account.

Many landlords refinance properties in order to raise funds to buy more properties. This does not change the capital within the business, providing the proceeds of the refinancing are all invested back into the business.

Equity is something entirely different and may well be a considerably higher figure than your capital. This is because equity in your business is the difference between the value of the assets owned by the business and its liabilities. If the business owns properties which have increased in value, this could show an increase in equity but not an increase in the value of your capital.

Assuming you now understand the above, you will appreciate that financing the extraction of money from the business will always reduce both your capital and your equity. The type of finance makes no difference whatsoever. It could be bridging finance, mortgages, development finance, overdraft, credit card or any other type of finance. The financing of capital withdrawn from a business is, therefore, a form of Capital Account Restructure and can occur at any time.

HMRC are quite happy for you to finance the withdrawal of your own capital from the business. Why wouldn’t they be? After all, it’s your money and it has already been subjected to taxation. The details can be found in this HMRC manual. However, if you finance the extraction of more than your capital from the business there will be taxation consequences, which again is logical. This is explained in this HMRC manual.

In theory, your own Accountants should be able to tell you whether you have a positive or negative capital account, simply by looking at your balance sheet. However, not all Accountants follow best practice of keeping balance sheets for their landlord clients. Ideally, they should do this for individual properties and the business as a whole. Failing to do so can be extremely risky, not only because it makes it extremely difficult to calculate Capital Gains Tax when properties or the business as a whole is sold, but also to calculate the 20% tax credit on Finance Costs which are further restricted by HMRC rules when business liabilities exceed the acquisition costs of the business, i.e. where an overdrawn Capital Account exists. As you may be aware, if your tax returns are presented inaccurately, HMRC can apply fines and penalty interest for any underpaid tax.

An overdrawn capital account is also known as “Latent Gains“. Essentially, this is because the business owner will have only paid tax on profits, not on the other money withdrawn from the business that resulted in their Capital Account going overdrawn. In many cases, this scenario exists as a result of finance companies ignoring the acquisition costs of properties when they allow refinancing. Despite this, HMRC will eventually get their tax, because the amount of finance outstanding when properties or a business is sold is not affected by the amount of finance secured against it. Note that an incorporation of a business is the sale of a business in exchange for shares. Incorporation Relief might be available to roll capital gains into the value of the shares in the company to which the business is being sold to. However, if the capital gains exceed the value of the shares created then Capital Gains Tax will fall due on the difference between the two.

We very much hope the above has provided you with a clearer understanding of what Capital Account Restructuring is.

If incorporation is deemed to be the correct direction for your business to go in, then working out whether you have “Latent Gains” (which could result in CGT falling due at incorporation as explained above) or whether you do indeed have an opportunity to finance the withdrawal of capital from your business prior to incorporation is an extremely important part of the planning process. A Property118 Tax Consultant will be pleased to work with you and your Accountants to ensure the number crunching is in order, prior to referring your case to our Joint Venture partners at Cotswold Barristers with a request for them to adopt our recommendations as their professional advice at the point of implementation. This is to give you the best possible levels of protection available.

Final note – an example of a Capital Account Restructure using an overdraft facility can be read via this link.

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