Turner Little looks at tax efficiency for a company who often re-invests in further property by way of expansion for tax reasons.
Under the UK’s current tax rules, the main benefits of using a company (as opposed to holding investment property personally) arise from the company’s ability to retain income. Something a company often does to enable re-investment in further properties by way of expansion.
Company taxation
If you own properties personally and are a basic rate taxpayer, you’ll be taxed at 20%, at 40% if you’re a higher rate taxpayer and at 45% if you’re an additional rate taxpayer. Meanwhile, a company itself is taxed at 20%, which provides a significant tax incentive for anyone who intends to retain profits in the company, rather than take them personally.
If profits are taken via dividend, there is an additional tax charge which arises. If taken by way of dividend, at an effective 0% if within the basic rate band, 25% in the higher rate band and 30.55% for an additional rate taxpayer.
The major benefit however, is to retain profits in the company for future reinvestment or even future distribution by way of dividend. Where a company’s shareholders are non-resident, profits can be extracted as dividends free of income tax (subject to various anti-avoidance rules). This saves the additional 20% higher rate, and 25% additional rate tax that would be payable. This serves as a major benefit to overseas residents wishing to invest in UK property by utilising a UK Company or even an overseas company.
Example
By way of example, a UK higher rate taxpayer receiving £20,000 in rental profits and having utilised their personal allowance on other income will, if they keep the property in their own name, pay £8,000 in income tax.
If they used a company instead of owning the property personally, this would be reduced to £4,000 corporation tax where profits are retained in the company. Even if they extracted 50% of the profits at £10,000, they’d still be better off as the additional income tax would be £2,500.
Simply extracting the balance of £16,000 (£20k profit – £4k Corporation Tax) would of course result in no benefit, albeit it allows flexibility in terms of which year to extract and thus enables one to better manage one’s tax position; the real benefit though is retaining the profit in the company.
What are the changes?
In the 2015 summer Budget, three main changes were announced which will impact on the tax efficiency of using a property company:
Individuals – amended tax treatment
- With effect from 6th April 2017, landlords who are individuals receiving rental income from residential property will suffer restrictions on the amount of tax deductions they can obtain in respect of mortgage interest and other finance costs.
- Landlords will not be allowed to deduct all finance costs from rental income in calculating their taxable profit; they will only be entitled to relief at the basic rate (currently 20%).
The measure will be introduced over a transitional period, as follows:
- As of the 2017-18 tax year, deductions from rent will be reduced to 75% of finance costs (i.e. 75% will be deductible in full as now), with the remaining 25% deductible at the 20% basic rate only.
- As of the 2018-19 tax year, deductions from rent will be lowered to 50% of finance costs (i.e. 50% will be deductible in full as now), with the remaining 50% deductible at the 20% basic rate only;
- As of the 2019-20 tax year, deductions from rent will fall to 25% of finance costs (i.e. 25% will be deductible in full as now), with the remaining 75% deductible at the 20% basic rate only.
- As of the 2020-21 tax year, all finance costs will be deductible at the 20% basic rate only.
It is important to note that this applies to individuals only; corporate landlords will not be affected. In addition, commercial property and furnished holiday lets are unaffected.
Amendments to the tax treatment of dividends
With effect from April 2016, the notional dividend tax credit will be abolished and a new £5,000 tax free allowance per year on dividend income will be introduced. Dividend income which is above the £5,000 allowance will be taxed at 7.5% for basic rate taxpayers, at 37.5% for higher rate taxpayers and 38.5% for additional rate taxpayers.
Currently, income tax on dividend income is charged at 10% for basic rate taxpayers (in practice this means no extra tax because the tax liability is the same as the tax credit). This rises to 32.5% for higher rate tax payers and 42.5% for additional rate taxpayers. The corporation tax rate (currently 20%) will be cut to 19% in 2017 and to 18% in 2020.
How does this affect property investment companies?
For companies where profits are retained, the changes will result in further tax savings as the rate of corporation tax is reduced. The changes to the tax treatment of dividends won’t, however, be impacted. The ability to deduct all finance costs will be a significant benefit.
For companies where profits are to be extracted, it will be a case of weighing up the financial cost of deduction and lower corporation tax against the increased tax on dividends. Whether it will make sense to use a company to hold UK property will therefore depend on the particular scenario. To give two examples:
Example one – Jack’s two properties
Jack owns two rental properties. Total rental income is £45,000 and mortgage interest is £10,000. Jack is a higher rate taxpayer, and has other income which utilises his personal allowance and basic rate band. From 2020 onwards if he personally held property he would be taxed on the £45,000 at 40% (£18,000). He would then obtain 20% tax relief on the £10,000 mortgage interest. This would reduce his tax bill by £2,000, to an amount payable of £16,000.
If Jack used a company, the company profits would be £35,000, which would result in a corporation tax bill of £6,300. If Jack retained the profits in the company, there would therefore be a significant tax saving. The full finance cost deduction and lower corporation tax really make a significant impact.
If Jack decided to take half of the profits, he would have dividends of £17.500. His dividend allowance of £5,000 would lower this to £12.500 and he would then pay tax on the dividends at 32.5%. Income tax would be £4,062. Consequently, he would still be paying significantly less tax by virtue of holding the property through a company.
Even if Jack had taken all the remaining profits of £28,700 as dividend, he would again offset his dividend allowance of £5,000 and pay 32.5% tax on the balance of £23,700 income which would result in income tax of £7,702.50p. Total tax would therefore be £14,002.50p; this is still a worthwhile saving over the £16,000 he would pay if he held the property personally. It is clear that using a company remains very attractive, due to the finance cost deduction and lower corporation tax which applies.
Example two – what though of larger profits?
Let us assume that an individual, Joe, had profits of £100,000 but still only £10,000 interest. We will also assume the £100,000 is within his higher rate band. From 2020 onwards if Joe held the property personally he would be taxed on the £100,000 at 40% (£40,000). Joe would then obtain 20% tax relief on the £10,000 mortgage interest, which would reduce his tax bill by £2,000. Income tax payable would therefore be £38,000.
If Joe used a company the company, he would pay 18% corporation tax on £90,000 profits. Therefore tax of £16,200 would be payable. Again a significant difference and using a company is always going to be more attractive if you are looking to retain profits in it.
However, if Joe were then to take all the remaining profits of £73,800 as dividend, the dividend allowance of £5,000 would be offset. The remainder would then be taxed at 32.5% and income tax of £22,360 would be payable. In this case total tax payable would be £38,560; a marginal disadvantage to using the company.
Specific circumstances
Each case therefore depends on the specific circumstances and intentions of the parties and in particular:-
- The level of finance costs?
- The tax rate the individuals are paying on property income?
- Whether profits will be retained in the company or taken as dividend and if so will dividends represent a partial or total extraction of profits?
Turner Little
Turner Little are happy to arrange corporate structuring be it for property ownership or any other purpose. See the Turner Little website for more details.
