Replies to Queries - Close co landlord

A client is considering renting his whole home (jointly owned with his wife) to his company, who will then in turn allow him to reside there and use one out of six rooms exclusively for business. My client is a higher rate taxpayer and his (close) company currently pays 19% corporation tax on all profits.

The property cost £50,000 in December 1998. According to the client, it is likely to be worth £260,000 in, say, five years' time.

I have calculated that the effective annual rate of income tax on rent charged to the company (which is equivalent to the annual mortgage interest paid) is 22.97%. If the company pays £2,887 in annual rent, then the director would have a benefit in kind charge of £962 (£2,887 (assuming this exceeds rateable value) x 5/6 rooms = £2,406 at 40%).

No liability would arise in respect of the rental income (i.e. rent of £2,887 less interest of £2,887).

The company would obtain relief on the rent £2,887 at 19% = £549. Class 1a NIC would be £307 (£2,406 at 12.8%), but relief would be obtained on that amount at 19%, i.e. £59, so that the net relief obtained by the company would be £301.

The total net tax charge would therefore be £661 (i.e. £962 — £301), equivalent to 22.9%. If the company pays full rate CT, then the above effective rate would reduce to just 10.8% or, alternatively, an annual rent could be charged of £4,150 to achieve the same effective rate as above.

It appears that over the five years of ownership the director could extract £14,435 at the above effective tax rate. My questions are as follows.

• Is business asset taper relief allowed on the whole gain on eventual sale of the property?

• Is lettings relief available to the director and his wife on this type of letting?

• Is main residence relief available to the director and his wife during the letting period because they happen to reside there too (given that only one-sixth of the property is actually used exclusively for business)?

• Does the additional charge (benefit in kind) apply where the company rents as opposed to buys the property? In this case the cost is only £50,000 and therefore it does not apply anyway.

• Would this arrangement be a tax avoidance scheme?

Readers' views on these points and any other comments are welcomed.

(Query T16,554) — Extractor.

There seems to be a major flaw in this plan. In order to avoid a CGT part disposal on the grant of the lease, a rack rent will have to be charged. But ITEPA 2003, s 105(4) requires the employee benefits income tax charge (and the attendant NIC) on the husband to be based on the rent actually paid (albeit reduced by one-sixth to allow for the allocation of one room as an office). It follows that a significantly higher figure is likely to be brought into charge at 41% without the ITEPA 2003,
s 106 'cash equivalent' charge being in point.

It is apparent, however, that the justification sought is to be in the CGT treatment on sale. As this property is the couple's main residence, the exemption would have applied in the absence of this scheme being put into operation. The presence of a study for a corporate employee might, however, have resulted in a disallowance of (say) one-sixth under TCGA 1992, s 224(1). However, the important word is 'might' for two reasons.

• First, the statutory wording can be interpreted as excluding the application of that subsection where the business use is by an employee.

• Secondly, that subsection does not apply where a material degree of private use is made of the room in question, even if largely set aside for 'employee' use.

However, if the scheme is put into operation, then the retention of the freehold interest appears, from the wording of TCGA 1992, s 222(1), to permit both husband and wife to continue to claim only or main residence exemption. In that event, clearly s 224(1) would exclude the 'office'. Assuming that the company comes within TCGA 1992, Sch A1 para 22A, then para 5(2)(a) would give business asset taper by reason of that. But the rules for the computation of the gain are such that taper relief is applied to the gain net of only or main residence exemption. The question then arises as to whether Sch A1 para 9(1)(b) ('cases where an asset is used at the same time for different purposes') should then be brought into the equation in order to limit that relief to one-sixth of the s 224(1) exclusion. A literal construction of the opening words of Sch A1 para 5(2) would suggest otherwise, but the House of Lords has now enjoined the courts always to apply a purposive construction. Under that, the Inland Revenue might well be successful on this point. — Vairao.

With regards to Extractor's first question, this seems almost too good to be true. Presumably the client would have to argue that the provision of the property is part of his 'remuneration package' and therefore used for business purposes. Perhaps the Revenue would argue that the property is not being used exclusively for the purposes of the trade; after all it was already the client's main residence and nothing has changed. A transaction has been inserted simply to gain a tax advantage.

With regard to the second point, are we talking about income tax or CGT lettings relief? The Revenue has previously expressed its opinion that CGT residential lettings relief is not available for most business letting. Simon's Direct Tax Service states that 'The extended relief under TCGA 1992, s 223(4) is only available where the dwelling house is "wholly or partly … let as residential property". The meaning of that phrase was considered in Owen v Elliott [1990] STC 469'. It later continues 'nor is [the relief] available in respect of property let for trade or professional use (unless let as residential accommodation)'. Or does the 'let' back to the director mean this qualifies?

Because one-sixth of the property is used exclusively for business purposes, the main residence exemption would not apply to that part. However, as the property remains in the ownership of the client and is used as his 'only or main residence', it seems that the conditions of TCGA 1992, s 223 are satisfied and relief should be available on the five-sixths. The answer could be to ensure that the business premises are not exclusively business, e.g. used as a spare room at weekends and evenings. Any business asset taper relief would presumably be tainted by virtue of the non-business use in the last ten years.

With regard to income tax relief against rental income, I have a doubt as to whether the client would be entitled to this. Would the Revenue argue that relief should only be given against one-sixth of the rent, as that relates to a business letting? The counter-argument is that the whole property is a business let, as the benefit in kind charge is the 'quid pro quo' for this. Could the Revenue disallow the whole of the rent as not being wholly and exclusively for business purposes under TA 1988, s 74(1)(a)?

Regarding the additional charge, as I see it, in most circumstances this would apply only where the company has purchased a property or spent heavily on improving it, such that the result of the formula in ITEPA 2003, s 104 was more than £75,000. I am not sure if s 104 is as clearly written as it could be. Could there come a point at which the total of all of the years' rent exceeds £75,000? Or would one argue that there is a new lease every, say, year, and the interest is only for that year? The 'special rule' in ITEPA 2003, s 107 does not apply as the company did not have an interest in the property throughout the six-year period before the client first occupied it.

I regret that this reply has not given definitive answers, but may have provided some 'food for thought' to be digested before Extractor embarks on this plan.

Issue: 3994 / Categories: