What Does “Washing Out CGT On Incorporation” Actually Mean?

by Mark Alexander

9:11 AM, 13th June 2018
About 4 months ago

What Does “Washing Out CGT On Incorporation” Actually Mean?

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What Does “Washing Out CGT On Incorporation” Actually Mean?

A common question I am asked by landlords who are considering incorporation of their property rental business is “what does washing out Capital Gains Tax (CGT) on incorporation actually mean?”.

I will explain this first using an analogy, which will make a lot more sense when I then relate it back to the question.

Imagine you have just cleaned a muddy floor with a white towel. The towel isn’t white any more is it? This is because the mud has been transferred from the floor onto the towel. The floor might well be clear of mud but the towel isn’t is it? The mud still exists, it has merely been transferred.

Now imagine washing the towel in a bucket of water. You can wash the mud out of the towel but it remains in the water doesn’t it?

In both scenario there is no less mud after the transition than there was before. You have simply moved the unwanted mud from an inconvenient position to a more convenient position for you.

In this analogy the mud represents the capital gains on which CGT is ordinarily payable. The towel represents shares in your new company and the bucket of water might represent a Real Estate Investment Trust “REIT”.

When a property rental business is transferred into a company it is treated as a sale, which triggers capital gains. However, a piece of legislation called TCGA92/S162 enables business owners to exchange equity in their business for shares and to offset the value of the shares created (the value of the equity in the business) against the capital gain resulting from the sale of the business, to reduce or even eliminate the payment of CGT at this point by deferring it. Effectively, the capital gains have been transferred from the properties into the shares in the company, much like the mud being transferred from the floor to the towel, or the towel into the bucket of water.

Imagine a scenario where a property was originally purchased for £100,000 but transferred to a company for £200,000. If that property was sold for £200,000 the following day, the company would have made no profit, hence there would be no capital gains. This is because the £100,000 of capital gain has been washed out of the property and into the company shares. Therefore, the CGT is deferred until the shares (not the properties) are disposed of.

However, there are two scenario’s at least where CGT would not fall due on disposal of the company shares. These are:-

  1. If the owner of the shares dies before they are transferred – rather an extreme way to avoid paying tax though!
  2. The second second is if the shares in the company are sold to a REIT. This is the equivalent to my analogy of washing the towel in the bucket of water.

The above often leads to another question; “what are latent gains?”

Latent gains occur when equity in your business is less that your capital gains. Capital gains are current value minus acquisition costs. Equity is current value minus liabilities. If a latent gain exists, it is because you have insufficient equity to convert into shares in order to offset all of your capital gains at the point of incorporation. Accordingly, CGT remains payable on the element of latent gains. There are only a few ways to avoid this problem. The first is to move abroad and become non-resident, in which case your acquisition costs are deemed to be the value of your business as of April 2015. The others are to reduce your debt, or to add assets to the business, so that your equity is the same level as your capital gains.

Our main “Tax Planning” page has several case studies based on the above scenario’s, the three most popular of which are linked below.

How Angie and Dan Could Have Saved £280,000

£1.7 million tax planning success

Expat Landlords Tax Planning Opportunity

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Comments

Glenn Ackroyd

11:53 AM, 18th June 2018
About 4 months ago

I can genuinely say that the tax consultation with Mark Alexander has paid for itself a thousand times over.

On the basis of this strategy, I've washed out all of my CGT and fingers crossed, I'll have a sale on my portfolio completing shortly.

My accountant who has lots of property clients has reviewed everything and say's its a work of genius.

David Hope

17:24 PM, 21st September 2018
About 4 weeks ago

Using TCGA92/S162 - do all of a Partnerships assets(properties) have to be transferred to the business, or can you choose to transfer only some of the properties ?

Mark Alexander

18:05 PM, 21st September 2018
About 4 weeks ago

Reply to the comment left by David Hope at 21/09/2018 - 17:24
To qualify for this rollover you must transfer the ‘whole business’

David Hope

18:45 PM, 21st September 2018
About 4 weeks ago

Reply to the comment left by Mark Alexander at 21/09/2018 - 18:05
Thanks Mark 🙁

David Hope

15:41 PM, 26th September 2018
About 3 weeks ago

Following the consultation on the best structure to go forward using BICT, what are the indicative timescales, 1 month, 2 months ? to complete the whole process - set up the loan account, complete bridging finance and complete the legals etc

Mark Alexander

16:05 PM, 26th September 2018
About 3 weeks ago

Reply to the comment left by David Hope at 26/09/2018 - 15:41
Within a month is realistic if no bridging finance is required. For cases requiring bridging finance it could take up to three months.

David Hope

16:16 PM, 26th September 2018
About 3 weeks ago

Finally I read somewhere to avoid the SDLT the partnership should be on the go for 3 years before incorporation, is that correct ?

Mark Alexander

16:28 PM, 26th September 2018
About 3 weeks ago

Reply to the comment left by David Hope at 26/09/2018 - 16:16
Three years is also the minimum partnership period we recommend to be comfortable that the partnership will be recognised by HMRC in regards to the advantageous treatment of Stamp Duty not afforded to sole owners as opposed to being a contrived tax avoidance structure.

David Hope

17:31 PM, 26th September 2018
About 3 weeks ago

Brilliant, thanks Mark - really appreciate it 🙂

Mark Alexander

17:48 PM, 26th September 2018
About 3 weeks ago

Reply to the comment left by David Hope at 26/09/2018 - 17:31
You're welcome David

If you are already operating a business and you share income, expenses and business related risks with other joint owners you may already be a partnership according to the 1890 act.

Qualification for the SDLT treatment of a partnership and registration of a partnership with HMRC are not linked.

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