HMRC Spotlight 63 – hybrid partnerships
When HMRC announced plans to restrict relief for finance costs on residential property to basic rate tax, there was an obvious long-term impact. Historically, landlords were able to offset mortgage finance costs against rental income to reduce their tax liability. The idea behind the move was simple; to remove the beneficial treatment available for landlords in the higher income tax brackets.
Over the years, we have seen several schemes attempt to circumnavigate the legislation, avoiding various types of associated tax. This has led to some high-profile disagreements, some of which have prompted the involvement of HMRC.
Calculating mortgage interest tax relief
In the 2017/18 tax year, HMRC began to taper in the changes to how mortgage interest tax relief was calculated. By the tax year 2020/21, the potential offset had been reduced to the equivalent of basic rate tax. Rather than offset finance costs against rental income, the landlord would pay tax on rental income and then receive a tax credit.
Rental income: £12,000
Mortgage interest: £7,000
Basic rate taxpayer
The situation where a landlord pays basic rate income tax is as follows:-
Tax on gross rental income @ 20%: £2400
Mortgage interest relief @ 20%: £1400 (tax rebate)
Net tax charge: £1000
Higher rate taxpayer
The situation with a landlord paying a higher rate of income tax is as follows:-
Tax on gross rental income @ 40%: £4800
Mortgage interest relief @ 20%: £1400 (tax rebate)
Net tax charge: £3400
Under the old system, tax rebates were based upon the net profit, i.e. gross rental income less mortgage interest. For a higher rate taxpayer, the net tax charge would have been £2000 instead of £3400 under the current system.
The landlord’s hybrid partnership scheme
Central to creating various hybrid partnership schemes is the fact that companies can still offset finance costs against income. Consequently, those companies owning property can reduce their corporation tax bill by offsetting mortgage interest payments. Many of these schemes missed that the personal and corporate mortgage markets differ, and transferring properties requires the lender’s approval.
One of the more controversial schemes, which prompted a direct reply from HMRC, involves using an LLP. In essence, the scheme was structured in the following manner:-
- Husband-and-wife landlords would establish an LLP
- In their individual capacity, each would become a member of the LLP
- Their properties would be transferred to a trust in favour of the LLP
- The landlords establish a company which becomes a member of the LLP
- The landlords retain voting shares in the company
- Their children acquire B shares in the company, related to asset growth
- The LLP is set up to divert most of the profits to the company
In theory, the main benefits of such a scheme would be as follows:-
- Under the trust set-up, all mortgage payments are the responsibility of the company, which can claim full tax relief on mortgage interest
- As income is diverted from the LLP to the company, this means an effective rate of between 19% and 25% on profits
There were also additional claims, such as:-
- Exemption from CGT/SDLT when the property was transferred to the trust
- An IHT exemption after two years due to business property relief
- Disposal profits based on the value of the properties on the day they were transferred to the trust in favour of the LLP
- Profits withdrawn from LLP as capital, thereby avoiding additional tax
- No obligation to report the transactions to HMRC
There were also suggestions that if the scheme were to trigger an unexpected tax charge, this would be covered by the adviser’s insurance arrangements.
HMRC and Spotlight 63
As discussed above, the promotion of the above scheme prompted a direct reply from HMRC under Spotlight 63, Property Business Arrangements Involving Hybrid Partnerships. After outlining the suggested benefits of the scheme and how it was set up, HMRC then went on to identify specific legislation which would nullify any financial gain:-
- Income Tax (Trading and Other Income) Act 2005, S850C and S850D
- Income Tax Act 2007, Chapter 5AA, S809AAZA
- Chargeable Gains Act 1992 S59A
- Inheritance Tax Act 1984, s105(3)
Cumulatively, these pieces of legislation address an array of issues, such as:-
- The treatment of excess profits from a corporate member of an LLP
- Anti-avoidance legislation regarding the transfer of an income stream to a corporate member
- Fractional asset ownership and the original base cost on transfer
- Exclusion from business property relief and the avoidance of inheritance tax
The issue of Spotlight 63 was a clearly defined wake-up call which, while focused on one particular scheme, was relevant to a number at the time. Interestingly, as part of the announcement, HMRC highlighted appropriate support and advised those using such techniques to withdraw and settle their tax affairs as soon as possible. They also provided a contact email, encouraging those involved in such schemes to contact them for further information.
As a side note, property owners must inform their mortgage lender if a property is being transferred. Failure to do so could see the mortgage move into default and action taken by the lender.
Schemes, tax avoidance and penalties
HMRC took the opportunity to highlight the responsibilities of those promoting schemes which may be seen to avoid tax and the potential penalties for those failing to abide by the legislation. Those promoting any scheme must ensure they are disclosed to HMRC and comply with disclosure of tax avoidance schemes legislation.
There are potential penalties where schemes are not disclosed to HMRC within five days of being available/implemented, which are:-
- Initial penalty of up to £600 per day
- Potential penalty of up to £1 million
As we saw with the issue of HMRC Spotlight 63, updates and guidance will be published where the authorities believe there have been specific infringements of the regulations. This may involve identifying those who promote and market such schemes. For those ignoring the regulations and repeatedly promoting illegal schemes, HMRC will actively pursue them under the Promoters of Tax Avoidance Schemes legislation.
HMRC Spotlight 63 Summary
In recent years, HMRC has become more proactive when pursing those who market and promote tax avoidance schemes. Where appropriate, updates will be released identifying individual schemes and how the theoretical benefits will be impacted by existing legislation. While offering a degree of support to those caught up in such schemes, rectifying their actions may lead to increased tax liabilities and additional penalties.
Tax management is a complex topic but one in which we have an array of expertise and an experienced team. Don’t hesitate to contact us to discuss any tax issues or the broader tax management of your financial affairs.