Taxation and acquisition vehiclesTypical tax issues and structuring
What are some of the typical tax issues involved in real-estate business combinations and to what extent do these typically drive structuring considerations? Are there certain considerations that stem from the tax status of a target?
When looking at the potential acquisition of a company which owns UK real estate the first thing to identify is the latent gain in the company. If this is significant it can make a share deal uneconomical or require a very significant price chip, depending on the nature and intentions of the buyer. The latent gain is the difference between the original acquisition cost (increased for any subsequent enhancement costs) and the price the property would be expected to be sold for on the open market. In the event the buyer procures and the target company disposes of the property, it might expect tax to be payable on the difference between the buyer’s cash outlay and the disposal proceeds. Instead, this concept of the latent gain requires looking back to the earlier acquisition by the target company. This is not a problem if the buyer intends, through its ownership of the target company, to hold the property indefinitely but if it intends to sell the property in the future, this latent gain must be taken into account in the price.
Although unlikely to be of relevance on the type of real-estate business combination under discussion, it is necessary to consider whether the property will be the buyer’s main residence or if it is a commercial building. As a result of the availability of principal private residence relief it would be extremely rare for a buyer to want to hold its main residence through a corporate wrap and one should consider the costs (tax and otherwise) of extracting the residence into the individual buyer’s hands. Historically, there was a balancing exercise with there being inheritance tax and SDLT advantages of holding property in this manner, but given the relatively recent annual charge on a person holding their own home through a property wrap and changes to the inheritance tax rules, this is becoming less common. (The annual charge is known as the Annual Tax on Enveloped Dwellings and can give rise to an annual charge of up to £226,950.)
The main advantage of buying a company rather than the property itself is often the differential stamp duties charges applying to properties and companies. Stamp duty on shares is payable at 0.5 per cent of the consideration, but does not apply to overseas companies if certain key formalities are kept offshore. By contrast, the SDLT on UK commercial premises is up to 5 per cent (which can be 6 per cent, if VAT is payable) and up to 15 per cent on UK residential properties. If a company purchase is undertaken it is not uncommon for the seller to insist the buyer’s savings in stamp duties is shared with the seller.
There is no point acquiring the property just to minimise the stamp duties charges and then have to claw back previously exempt transactions. It is therefore important to understand if a relief from SDLT was claimed when the property was originally acquired by the target company. The two most common such reliefs are the charities exemption and group relief (with a group here being a 75 per cent or more relationship).
Having identified that a corporate acquisition is still potentially advantageous, it is then necessary to identify what the historic tax risks are. In terms of property taxes, the two largest tax risks to look for in due diligence are in relation to historic VAT and SDLT planning. For most businesses, VAT is not a real cost as it can be offset against the ongoing VAT it charges its customers. Such businesses would rarely undertake overly complicated VAT planning (see ‘Asset deals’ below regarding the constantly evolving topic of the ‘transfer of businesses as a going concern’ (TOGC)). However, VAT is a real cost to businesses in certain sectors - principally banks, insurance companies and those in the health sector. If the underlying property is not a principal residence, but still caters for people to sleep in it (eg, student accommodation or care homes), there are a large number of traps to look out for; some are real and will give rise to a tax cost whereas others are theoretical and HM Revenue & Customs (HMRC) is prone to not take the point, but risk lies in both areas).
There was a tendency to consider stamp duty or SDLT as an optional taxes and a large number of tax avoidance schemes sprang up to reinforce this belief. Generally, it would be extremely rare for the target company’s property acquisition to have been structured via such a scheme and HMRC still be in time to challenge these, given the change in the law and attitude in the last six years, but this is always worth checking.
It is extremely rare to see a target company undertake aggressive tax planning in connection with the Construction Industry Scheme, but it is possible to fall foul of this if the vendors were unaware of it. Generally HMRC does not have a high regard for the compliance capabilities of those in the construction industry and expects those specialising in the area to hold back up to 30 per cent of payments to workers and businesses in their supply chain. It is possible to get approval from HMRC to not deduct, but this is predicated on the assumption that the business being paid has been tax-compliant. Ignoring it can give rise to large penalties and if the business being paid turns out to have been non-compliant HMRC will look to the paying entity.
The availability of capital allowances going forward can minimise the corporation tax costs of the target company which is similar to depreciation, but in the tax field.
Ideally, the target company will not have had officers or employees, but if it did payroll compliance will be another key issue.
Further issues arise if the target company had an unusual status, such as being resident offshore. Recent changes have made it harder to keep the whole profit of a construction project outside the UK tax net but in any event, even with the best laid plans, if there was a large construction cost, there is a significant risk that HMRC may try to argue that the target company was within the UK tax net. This could be, for example, on the basis that it was resident in the UK, it had a long-standing building operation in the UK or other permanent establishment. HMRC has been known to drill down into immigration records and mobile phone bills, and will want to know where the ‘deciding mind’ of the target was located.
The overarching message given by sellers is often that the target company is clean but it is imperative to check this quickly. A buyer will decide whether the target company is clean from a quick look at its tax history. If it is not clean, it can proceed to an asset deal without the wasted time and costs of detailed tax and other due diligence.
From a tax point of view, the direct purchase of the land will almost always be simpler than the acquisition of a company or other special purpose vehicle (SPV). However, it will come with a charge to SDLT, which, as noted above, is up to 5 per cent on UK commercial premises (which, in practice, can be 6 per cent if VAT is payable) and can be up to 15 per cent on UK residential property.
The two main tax challenges on a property acquisition are in connection with capital allowances and VAT.
If the seller incurs significant amount of plant and machinery costs it can ‘write this down’ for tax purposes over time and if the whole write down has not yet taken place there is often a debate as to how much of this should remain with the seller and how much should be passed to the buyer. Ideally this would be recorded in the heads of terms by reference to the mechanism for passing this to the buyer (known as a ‘198 election’ after the section in the relevant piece of legislation). More often than not, the quantum of that election would be at what is known as the ‘tax written down’ value, in the seller’s tax computations. This is the cost of the qualifying plant and machinery written down for tax purposes as at the seller’s last financial year end.
As regards to VAT, the first point to make is that if a buyer pays VAT this increases the SDLT cost, because SDLT is payable on the actual price, which is the sum including VAT. While this may seem unfair, there is no getting round it.
However, if the purchase of the property is essentially the property of a business (most commonly in these scenarios, the acquisition of a property letting business) then the acquisition is known as a TOGC and the transaction is outside the scope of VAT. This has the effect of reducing the SDLT cost. However, this has the effect of passing a significant element of the seller’s VAT history to the buyer for a period of up to 10 years following the acquisition, which gives rise to due diligence issues. Moreover, the buyer can easily breach the conditions for a TOGC without the seller’s knowledge and so a seller will be (rightly) cautious if the buyer is a new company or heavily leveraged.
It is possible to structure deals so they are not a TOGC, but given the SDLT advantages of TOGCs this is rare. In any event the risks of a TOGC are usually minor compared to a share purchase and it is important to remember this is against the backdrop that a direct freehold property purchase does not come with the burden of taking on the baggage of acquiring a company (eg, tax compliance and otherwise). However, while not a tax point, employment advice should be taken if there are staff working in the business in case these transfer across to the buyer automatically as a result of a TOGC, on the basis that this becomes a TUPE transfer (see response to 23 below).Mitigating tax risk
What measures are normally taken to mitigate typical tax risks in a real-estate business combination?
The first key way to mitigate risk is to understand it and therefore, however the deal is to be structured, some tax due diligence needs to be undertaken. This will be more extensive for a share purchase than a direct property purchase, but is necessary in both.
Even if risks are not identified in this due diligence process, it is common to have contractual protections in the documentation.
In the property context, this will start with what is known as Replies to Enquiries, which are in an industry-standard form. Only some of these relate to tax. Furthermore, the agreement itself will contain tax warranties and a VAT clause that, together with the provisions dealing with capital allowances, routinely run to four pages.
By contrast, in a share acquisition the tax warranties will run to somewhere between five and 10 pages and will often be caveated by the disclosure letter. These warranties will be given on the basis that if there is no loss to the buyer as a result of inaccurate warranties no claim can be made. It is therefore routine for a tax covenant to be given by the seller to the buyer essentially promising to pay any unexpected tax liability of the target company to the extent it arose before completion. This is given on an indemnity basis and therefore allows a pound-for-pound recompense.
The risks of taking on the tax history (and other compliance matters) of a target may not be acceptable to the buyer, and should issues arise the deal will sometimes move from a share purchase to a property purchase. Making this choice early on will save wasted fees.
The alternative is insurance. The UK market for warranty and indemnity (W&I) insurance has significantly increased in the last five to 10 years, with almost all types of tax risk in the property world being insurable so long at the insurers feel it is a risk rather than a more likely event or if it relies on HMRC not spotting the issue. This type of insurance is normally taken out by the buyer, but is often funded by the seller (at least in part).Types of acquisition vehicle
What form of acquisition vehicle is typically used in connection with a real-estate business combination, and does the form vary depending on structuring alternatives or structure of the target company?
Typically, acquisition vehicles have been offshore limited liability companies or unit trusts, in the latter case particularly JPUTs and GPUTs. Where tax considerations permit or dictate otherwise (eg, where trading business combinations are involved) on-shore limited liability companies, LLPs or English limited partnerships are typically used. All of the above vehicles will commonly be SPVs for a specific property asset or project and will sometimes be used to facilitate joint-venture arrangements between funders and developers or developer to developer.
The use of an SPV theoretically allows the buyer to ring fence its liabilities, whether relating to funding or otherwise, within the specific vehicle - provided always that no additional security (eg, a guarantee) is required by funders or third-party contractors.