Does it make business sense for the owners of commercial property to charge rent to associated tenant companies?
It’s a debate that has usually been settled by calculating the benefit of Entrepreneurs’ Relief against that of Capital Allowances.
Entrepreneurs’ Relief cannot be claimed on a rented property, and many owners have previously chosen to not levy rent to make the most of ER, which is usually more generous than Capital Allowances. But business owners may need to reconsider their plans after Chancellor Rishi Sunak brought in a number of changes in this year’s Budget.
When businesses assets are sold, Entrepreneurs’ Relief can cut the amount of Capital Gains Tax (CGT) due. Entrepreneurs’ Relief gives individuals – but not companies – a lifetime ceiling of qualifying gains from the scheme. This ceiling has soared from £1 million at its introduction in 2008 to £10 million from 2011.
Under the scheme, CGT is reduced from the standard 20% to 10% for qualifying gains on disposed assets used in the running of business (including goodwill in some cases). The term ‘business’ covers all trades, professions and vocations, but excludes the letting of a property, unless it is a furnished holiday let.
Companies and individuals can offset the expense of qualifying plants and machinery against their profits by using Capital Allowances. To be eligible, businesses must meet one or more of the qualifying activities.
A common activity is that of an ordinary property business. This requires that a property owner leases the premises to a tenant, who occupies or sub-lets the property and pays a market-rate rent to them as a landlord.
If the owner is leasing to a third party, it is likely that they purchased the site as an investment and is billing the market rate for their property. An example of this might be a high street retail unit being tenanted by a retailer.
Connected landlord and tenant
Many commercial sites are owned by an individual while an operating company leases the site and trades from on a day-to-day basis. So, for example, Joe Bloggs might own a commercial property, with Bloggs’ Blogging tenanting and trading from the premises as a computer shop.
Given that Joe is moving cash from one entity to another, it would be understandable if Joe didn’t charge his own company any rent.
But in doing so, he would fail to meet the criteria of being an ‘ordinary property business’, meaning that he would be unable to claim Capital Allowances on the qualifying fixed plant installed at the site.
Also, if rent is only charged at a reduced rate that, say, only covers the mortgage interest, this would not be considered a market-rate rent. In this instance, Capital Allowances can still be written down, but the claimable amount will be reduced based on the actual rent charged and the going rate.
When faced with connected parties with no rental agreement, we must consider whether to advise clients to charge a rent to qualify for Capital Allowances by satisfying Section 15 (1) CAA 2001.
Introduce a Rent?
A rented property does not qualify for Entrepreneurs’ Relief. If an individual is charging rent, the site is considered an investment and not a business asset. This means that the individual can claim either Capital Allowances if they charge rent or Entrepreneurs’ Relief if they don’t.
The question of which one is more beneficial is dependent on the Capital Allowances available and any gains made when disposing of the assets.
William’s Widget Workshop
Mr William Wilberforce purchases a site for £5 million and his company William’s Widget Workshop Ltd produces widgets on the site. William doesn’t charge rent and sells the facility 20 years later for £15m.
Since no rent was charged, the site doesn’t qualify for Capital Allowances, but Entrepreneurs’ Relief can be claimed on the gain of £10 million.
Tax relief is available as follows: £10 million x (20% – 10% = 10%) = £1 million.
With rent charged
In this instance, William charges his firm a market-rate rent. Entrepreneurs’ Relief cannot be claimed on the £10 million gain, but now Capital Allowances is an option. Qualifying assets are valued at £1.25 million, and if William is a higher-rate taxpayer, the tax relief available is calculated as: £1.25 million x 40% = £500,000.
In these examples, Entrepreneurs’ Relief has a greater benefit than Capital Allowances, so William would be advised not to charge rent.
Another interesting point is that the benefit from Capital Allowances is obtained over many years (18% Writing Down Allowance (WDA) in this example) whereas the Entrepreneurs’ Relief benefit is realised instantly.
Now let’s look at situations in which the property owner would have been advised to charge rent.
Bob Burns purchases a retail site in 2010 for £1 million from which his company Bob’s Books Ltd then trades. The site is sold in 2015 for £1.25 million, with Bob having never charged rent to the company.
With no rent charged, the property has not qualified for Capital Allowances, but Entrepreneurs’ Relief can be applied to the £250,000 gain, meaning tax relief of £250,000 x (20% – 10% = 10%) = £25,000.
With rent charged
Were a market-rate rent to have been charged by Bob Burns to the company, Entrepreneurs’ Relief would no longer be available on the gain of £250,000, but Capital Allowances would be allowed.
The qualifying assets are valued at £200,000 and qualify in part for Annual Investment Allowance (AIA). If Bob is a higher-rate taxpayer, he could access tax relief equal to £200,000 x 40% = £80,000.
In Bob’s case, the Capital Allowances benefit is larger than that of Entrepreneurs’ Relief, so he would be better off charging rent.
Changes in the 2020 Budget
Since accountants don’t know what value an asset will realise until it is sold, it is difficult to advise clients on the best course of action. By the time assets are sold, it is too late to introduce a rent.
Since Entrepreneurs’ Relief usually yields the greater benefit, Catax has never advised clients to start charging rent. But Chancellor Rishi Sunak’s Budget changes have made a hard decision simpler. Instead of abolishing Entrepreneurs’ Relief, he reduced the lifetime limit from £10 million to £1 million on disposals made from 11 March 2020.
What does this mean?
Returning to our first example, if William sold his facility today for the same price, he would have a £1.9 million CGT liability:
£1 million x 10% = £100,000
(£10 million – £1 million = £9 million) x 20% = £1.8 million
Total CGT liability = £100,000 + £1.8 million = £1.9 million
Entrepreneurs’ Relief now only creates a tax relief of £100,000, but had he charged rent, there would have been £500,000 Capital Allowances available. This change to the lifetime limit of Entrepreneurs’ Relief has reduced the tax relief so dramatically that Capital Allowances are now the better option for William.
Back in play
Previously, Entrepreneurs’ Relief was a more generous tax relief for individual owners of commercial properties with connected tenant firms, but the reduction in the lifetime limit swings the dial in the favour of Capital Allowances in many cases.
Since Entrepreneurs’ Relief is an allowance spread over a lifetime, the £1 million limit may well, for example, cover a company’s sale (i.e. its shares). However, this low limit makes it less likely that there will be any lifetime allowance left for property disposal, with excesses taxable at 20%.
In addition, charging rent is an efficient way to draw funds from a company without the burden of National Insurance.
Capital Allowances have enjoyed a resurgence thanks to the Chancellor’s changes. Those who own commercial properties and lease them rent-free to their company should think again about their rental strategy and evaluate the pros and cons of Entrepreneurs’ Relief and Capital Allowances. For many, the latter may now offer larger benefits.
Mark Anthistle, Senior Capital Allowances Analyst at specialist tax consultancy Catax