There is a plethora of issues that parties must resolve to make a strategic land project viable; in particular the British tax system which presents a number of potential pitfalls that can have a significant impact on returns.
At present, there is no single effective tax model provided for in UK law for the parties to come together. Instead, landowners should consider a number of potential ways to structure a project and seek to choose the structure that best suits their situation and needs. The tax treatment of the parties may vary considerably depending on the factual context and the structure adopted and, in addition, there may be significant uncertainty as to the tax treatment in borderline cases.
We understand that HMRC has recognized that tax is a barrier to some “land pooling” agreements, but there is understandably a tension at this time for HMRC between providing a simplified pooling rules. common land and increasing pressure from the treasury to collect as much tax as possible. As such, it seems unlikely that reform of the existing rules will happen soon, if at all.
From this perspective, it is crucial to keep in mind certain tax traps for the unwary. While trade agreements should not be guided solely by the tax outcome, business decisions must be informed by it; this is an area where there can be undesirable results if the potential tax results are not carefully considered. Some of these pitfalls can be illustrated using a simplified case study:
Party A is an individual owner of Land A valued at £ 1million and Party B is an individual owner of Land B valued at £ 3million.
Party A and Party B wish to pool their land to form a combined site (the “Site”) with a view to maximizing development potential. They undertake to apply together for an urban planning permit, to possibly carry out certain infrastructure works, to promote the Site and to find a buyer for it.
Ultimately, the intention is that Party A takes ¼ of the net profits and Party B, to match the proportion of the original land values.
Below, we outline three structures commonly used on strategic land projects, and the complexities to consider will emerge from our review of the overall tax issues that arise. In this article, we can only cover these issues very broadly, and we do not offer any consideration of the VAT treatment of each device. We can only offer a summary illustration and the tax treatment of a given project will depend on the specifics of this transaction.
Option A – Pooling of land using a separate vehicle
Party A and Party B could create a vehicle (“JV Entity”) (being either a corporation or a limited liability company (“LLP”) and transfer land A and B to the JV entity. Party A will own ¼ of the Entity and Party B JV ¾ (ie to match the original land ownership) The JV Entity will then promote the combined land and ultimately dispose of it to the buyer.
Housing tax issues when using a separate vehicle:
- Initial Tax Charges: In order for a separate vehicle to be used, the vehicle must be “seeded” with landowners transferring their respective properties to the vehicle.
In itself, this will give rise to taxable transactions with the JV Entity likely to be subject to land stamp duty (SDLT) depending on the market value of the property sold and the owners potentially subject to capital gains tax. (CGT) or income tax when they transfer their land interests.
These potential tax obligations will be due notwithstanding the fact that neither Party A nor Party B have yet received any product for the Site and notwithstanding the fact that a third party buyer may never be found. However, given the possibility of an increase in capital gains tax rates in the future, we have seen landowners willing to incur these “dry” tax burdens in order to “lock in” the rate. current tax to be applied against the historical increase in value. in their property. A landowner may also want to ‘lock in’ the availability of CGT divestiture relief (formerly known as ‘contractor relief’), 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 should also be considered and the treatment will depend on the use of a corporation or LLP.
If the JV Entity is a company, it will be subject to corporation tax on the profits made from a sale of the Site. In addition, Parties A and B will be subject to income tax on a distribution by the company of after-tax profits (or CGT on receipt of the proceeds from a liquidation of the company, subject to certain anti-avoidance laws). This double taxation must be taken into account.
An LLP is generally considered ‘transparent’ for capital gains and income tax purposes, meaning that the LLP itself will not be taxable (thus avoiding the double layer of taxation mentioned above. ). However, it is likely that the LLP will be considered a “business” for tax purposes, even where Parties A and B previously held their land as an investment. 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 – Equalization agreements
Party A and Party B each retain ownership of their respective land, but agree to work together to promote the site and share costs and revenues in proportion to the value of the land each owns. This objective will be achieved through equalization payments.
Tax issues when adopting equalization arrangements
- Risk that the proceeds of the sale will be taxed twice: since the parties will each retain ownership of their respective lands, there should not be any initial ‘dry’ tax burdens as a result of the conclusion of the equalization agreements ( assuming that the parties have not formed a common law company). However, when one or both parties hold their land as an investment and due to the strict capital gains tax regime, this may result in double taxation of the proceeds of the sale.
Suppose Party A and Party B receive 12 million (i.e. 6 million pounds each) when the development site is transferred to a third party buyer. Party A will make an equalization payment of £ 3million to Party B. The CGT for Party A will be calculated by reference to its share of £ 6million of the proceeds received from the buyer, without any deduction for the £ 3million paid to Party B. Party B will be taxed by reference to the £ 6million of product received from the buyer plus the £ 3million received from Party A. In this way the equalization payment is, in effect, subject to double taxation.
Option C – Trust Agreement
Party A and Party B transfer the legal interest in Lands A and B to two Trustees (“Trustees”). The trustees hold lands A and B in simple trust for Parties A and B. Parties A and B end up owning an undivided share of the site, their right to the proceeds being proportional to the value of the land to which each has been transferred.
Based on the current understanding, the transfer of the land into the trust should not give rise to any capital gains tax or stamp duty, and furthermore, there should be no impact of double taxation when the site is sold and the parties receive the sale. proceed in their appropriate proportions.
Tax issues when adopting trust agreements
- 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 that HMRC is seeking to distinguish a particular land-pooling agreement with the decision in this case (or even seek an alternative outcome through the courts). Although HMRC has confirmed that a similar analysis applies for the purposes of the SDLT, this is not spelled out in law and is not without doubt. Finally, great care must also be taken in the implementation of the trust agreement to ensure that it is carried out in a manner consistent with case law.
- Unavailability of the relief for the sale of commercial assets (“BADR”) This may be less of a problem now that the lifespan limit has been reduced, but parties A and B would not be able to claim BADR on the sale of the site, since party A will not have owned or used Land B in his business and neither Party B owned or used Land A.
- Risk of tax treatment As above, parties could find themselves subject to income tax rather than CGT if land is allocated for commercial actions or if certain anti-avoidance laws apply.
Given these many potential tax traps, expert advice should be sought before entering into any form of land collaboration agreement.
Shoosmiths is able to offer strategic land advice drawing on the expertise of all of its real estate and tax teams. For more information, please do not hesitate to contact our named contacts.