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Equity or loan?

An individual client acquired a property for £725,000, with a secured loan of £290,000 from an otherwise unconnected individual.

The mortgage provides for the borrower to repay the principal sum on sale of the property with 40 per cent of the sale value. The lender is unable to influence the disposal date unless the borrower gifts the property, borrows money secured on it, etc.

Assuming that the property is eventually sold at a gain, the 'premium' realised by the lender will clearly be partly for the use of the money, but is it interest or could the loan be a relevant discounted security? If neither, is it a capital gain and is this taxable, given that a debt is exempt in the hands of the original creditor?

Staying with the 'capital' theme, what is the relationship between the two parties? Has the lender acquired an interest in the property or a chose in action? Clearly he has acquired a contractual right which must be an asset, but it is difficult to see how the client has made a disposal. But that would mean the base cost is unaffected, even though the client has effectively reduced his interest in the property by 40 per cent. In that case, would the client also be taxed on the whole gain as the payment to the lender is merely discharging a debt and thus does not affect the computation of the gain? Does the client become a trustee of a bare trust for himself and the lender; though, if so, presumably this will not affect the tax analysis, as both are absolutely entitled?

(Query T16,493) — Borrower.

At this stage, we cannot calculate the level of the discount since we do not know when the amount will be repaid and nor do we know how much will be repaid. It is always possible that something might happen so that the property is sold at a loss. However, if the property were to be sold for twice the amount paid, the lender will receive £580,000, a profit of 100%, and the loan looks like a relevant discounted security. Since a profit on such a security would be taxed under Sch D, Case III, as would interest, there seems little point in examining the point any further and producing hypothetical calculations.

I am making a couple of assumptions. First, I assume that the property is not a principal private residence. Secondly, I assume that the facts are as presented and there is nothing in the paperwork to give the lender any rights over the property.

We can immediately discount (please pardon the pun) any capital disposal by either the borrower or the lender. On receiving repayment of the loan, the lender is receiving an amount under the agreement plus an amount for the use of that money. The profit element is not a capital gain and, therefore, we do not need to look at TCGA 1992, s 251 to exempt the profit. The profit is charged to income tax and not capital gains tax.

It is true that the lender has acquired a right. The right is to be paid an amount of money at some time in the future dependent on a future event. It looks even as if the lender cannot enforce the security in the most expected circumstance since the amount is to be repaid once the property is sold. The borrower has not made a disposal of any part of the property. What he has done is agreed to pay an amount for the money based on the eventual sale of the property. As such, the client will be taxed on the full profit of the property. The amount by way of interest might be allowed against any profits that are taxed in respect of the property if it is let or is used in a business, but I do not have enough information here.

I will add one point, however. The position looks a bit more complicated than the average loan and I would double-check the paperwork to ensure that there is nothing within it to change the facts as presented.

Issue: 3979 / Categories: