There are a plethora of issues that parties need to work through to make a strategic land project viable; not least, the UK tax system which has a number of potential pitfalls that can materially impact returns.
At present, there is no single tax efficient model catered for in UK legislation to enable parties to come together. Instead, landowners must consider a number of potential ways of structuring a project and seek to choose the structure that best suits their circumstances and needs. The tax treatment of the parties can vary significantly depending on the factual background and the structure adopted and furthermore there can be significant uncertainty over tax treatment in borderline cases.
We understand that HMRC have acknowledged that tax is a barrier to certain “land pooling” arrangements but there is understandably a tension at this time for HMRC between providing a simplification of the rules relating to land pooling and increasing pressure from the Treasury to collect as much tax as possible. As such, it seems unlikely that a reform of the existing rules will happen soon, if at all.
In view of this, it is crucial to bear in mind certain tax traps for the unwary. Whilst commercial deals should not be led solely by the tax outcome, commercial decisions must be informed by it; this is an area where there can be some unwelcome results if the potential tax outcomes are not considered carefully. Certain of these traps can be illustrated by way of a simplified case study:
Party A is an individual owning Land A, valued at £1m and Party B is an individual owning Land B, valued at £3m.
Party A and Party B wish to pool their land to form a combined site (the “Site”) with a view to maximising the potential for development. They agree to seek planning permission together, possibly carry out certain infrastructure works, promote the Site and find a buyer for it.
Ultimately, the intention is for Party A to take ¼ of the net profits and Party B ¾, to match the proportion of the initial land values.
Below, we set out three commonly used structures on strategic land projects and, the complexities that need to be considered will be apparent from our examination of the headline tax issues that arise. In this article we are only able to cover these issues very broadly and we do not offer any examination of the VAT treatment of each arrangement. We can offer only an outline illustration and tax treatment of a given project will depend on the specifics of that transaction.
Option A - Land Pooling using a separate vehicle
Party A and Party B could set up a vehicle (“JV Entity”) (being either a company or limited liability partnership (“LLP”) and transfer Land A and Land B to the JV Entity. Party A will own ¼ of the JV Entity and Party B ¾ (i.e. to match the original land ownership). The JV Entity will then promote the combined land and ultimately dispose of it to the buyer.
Headline tax issues when using a separate vehicle:
- Up-front tax charges: In order for a separate vehicle to be utilised, the vehicle has to be “seeded”, with the landowners transferring their respective properties to the vehicle.
In itself this will give rise to taxable transactions with the JV Entity likely liable to stamp duty land tax (SDLT) based on the market value of the properties transferred and the landowners potentially liable to capital gains tax (CGT) or income tax on their disposal of their land interests.
These potential tax liabilities will fall due notwithstanding that neither Party A nor Party B has received any proceeds for the Site yet and notwithstanding that a third party buyer may never be found. However, given the possibility of capital gains tax rates rising in the future, we have seen landowners prepared to suffer these “dry” tax charges in order to “lock-in” the current rate of tax to be applied against the historic increase in value in their property. It may also be the case that a landowner may want to “lock-in” the availability of business asset disposal relief (formerly known as “entrepreneur’s relief”) from CGT, although the importance of this relief has diminished in recent years.
- Tax treatment of the vehicle: The longer-term tax consequences of using a JV Entity must also be considered and the treatment will depend on whether a company or LLP is used.
If the JV Entity is a company, it will be subject to corporation tax on the profits realised from a sale of the Site. Furthermore, Parties A and B will be subject to income tax on a distribution from the company of the post-tax profits (or CGT on receipt of proceeds on a winding up of the company, subject to certain anti-avoidance legislation). This double layer of taxation needs to be taken into account.
An LLP is generally treated as “transparent” for capital gains and income tax purposes, meaning that the LLP will not itself be taxable (thus avoiding the double layer of tax referred to above). However, is likely that the LLP will be regarded as “trading” for tax purposes even where Parties A and B had previously been holding their land as investments. This means that Parties A and B are likely to be subject to income tax rather than CGT on their share of the profits from the sale of the Site.
Option B - Equalisation Arrangements
Party A and Party B each retain ownership of their respective land but agree to work together to promote the site and to share costs and proceeds in proportion to the value of the land each owns. This will be achieved by way of equalisation payments.
Headline tax issues when adopting equalisation arrangements
- Risk of sale proceeds being taxed twice: As the Parties will each retain ownership of their respective land, there should be no up-front “dry” tax charges as a result of entering into the equalisation arrangements (assuming the parties are not found to have formed a general law partnership). However, where one or both of the parties holds their land as an investment and due to the strict capital gains tax regime, this can lead to sale proceeds being taxed twice.
Let’s say that Party A and Party B receive 12m (i.e. £6m each) on a disposal of the Development Site to a third party buyer. Party A will make an equalisation payment of £3m to Party B. Party A’s CGT will be calculated by reference to its £6m share of proceeds received from the buyer, without any deduction for the £3m paid to Party B. Party B will be taxed by reference to the £6m of proceeds received from the buyer plus the £3m received from Party A. In this way, the equalisation payment is, in effect, subject to double taxation.
- Risk of income tax treatment: Party A and Party B will normally expect the sale proceeds from the disposal of the Site to be taxed as capital (and subject to lower rates of tax ) However, care needs to be taken to ensure that the Parties do not “appropriate” their long-term land holdings to trading stock, as the outcome can be that some or all of the sale proceeds are taxed as income. Whether land is held as an investment or trading stock can be a finely balanced question where land is concerned and there are certain actions that the Parties may wish to avoid taking prior to sale (e.g. undertaking physical development works at the site).
Separately, the Parties need to consider the application of anti-avoidance legislation which can impose an income tax charge on the parties.
Option C - Trust Arrangement
Party A and Party B transfer the legal interest in Land A and Land B to two trustees (“Trustees”). The Trustees hold Land A and Land B on bare trust for Party A and Party B. Party A and Party B end up owning an undivided share in the Site with their entitlement to proceeds being proportionate to the value of the land that each transferred in.
Based on current understanding, the transfer of the Land into the trust should not give rise to any capital gains tax or stamp duty land tax liabilities and furthermore, there should not be incidences of double taxation when the Site is sold and the parties receive the sale proceeds in their appropriate proportions.
Headline tax issues when adopting trust arrangements
- Uncertainty of tax treatment The analysis which confirms that no capital gains tax is applicable on the transfer of the land into the trust is based on a case which is now over 30 years old and we cannot rule out HMRC seeking to distinguish a particular land pooling arrangement with the decision in that case (or indeed seek an alternative outcome through the Courts). Whilst HMRC has confirmed that a similar analysis applies for SDLT purposes, this is not set out in statute and is not free from doubt. Finally, considerable care also needs to be taken around the implementation of the trust arrangement to ensure that it is undertaken in a manner which is consistent with case law.
- Unavailability of Business Asset Disposal Relief (“BADR”) This is perhaps less of an issue now that the lifetime limit has been reduced, but Parties A and B would be unable to claim BADR on the sale of the Site, since Party A will not have owned or used Land B in its business and neither will Party B have owned or used Land A.
- Risk of income tax treatment As above, the parties could find themselves liable to income tax rather than CGT if land is appropriated to trading stock or if certain anti-avoidance legislation applies.
In view of these plentiful potential tax traps, expert advice needs to be sought prior to entering into any form of land collaboration arrangement.
Shoosmiths is able to offer strategic land advice drawing on expertise from across its real estate and tax teams. For more information please do not hesitate to get in touch with our named contacts.