Satwaki Chanda discusses the rules on how corporate landlords obtain tax relief on their interest expenses.
As is well known by now, the Government has been clamping down on buy-to-let landlords by restricting interest relief for individuals. These restrictions don’t affect companies, so that operating through a corporate vehicle sounds like an attractive alternative. In fact, as we shall see, the rules for companies are more favourable, both for commercial and residential landlords.
Starting point: corporate landlords cannot deduct their interest costs when calculating rental profits
This is a startling statement to make, given the title of this article! But technically it is true, since the legislation specifically states that for corporation tax purposes (CTA 2009, s 211(1)):
‘The profits of a property business are calculated without regard to items giving rise to –
(a) credits or debits within Part 5 (loan relationships)…’
The loan relationship regime is the tax code which specifically deals with the way in which companies can claim relief for their borrowings. It seems at first that there is an outright prohibition on deducting interest costs when conducting a rental business, but it turns out that this is the key to why corporate landlords are better off than their individual counterparts.
In order to see why, we need to take a closer look at the loan relationships rules.
So how do corporate landlords get tax relief for their borrowing costs?
The rules on loan relationships can be summarised as follows:
- a loan relationship is one where the company stands as a creditor or debtor in relation to a money debt that arises from a transaction for the lending of money (CTA 2009, s 302(1). So a bank loan to finance a property acquisition is a loan relationship (as one would expect);
- profits on a loan relationship are chargeable to corporation tax as income (CTA 2009, s 295(1));
- profits and losses are computed in accordance with credits or debits, as they are recognised in the company’s profit and loss account in accordance with generally accepted accounting practice (CTA 2009, s 307);
- for trading loan relationships – where a loan is made for the purpose of a trade – credits are treated as trading receipts, while debits are treated as trading expenses (CTA 2009, s 297); and
- for non-trading loan relationships – such as a loan taken out to finance a property business – credits and debits are netted against each other. However, unlike the case for a trading operation, surpluses and deficits are taxed and relieved separately from the business profits (CTA 2009, ss 299-301; Pt 5 Ch 16).
The last point provides the key to how tax relief is given for corporate landlords. Broadly, the rental profits are calculated first and only then is it permissible to deduct interest costs. The latter are tax deductible but never form part of the property profits.
Example 1: how much profit?
Suppose that we have a property business and the profits before interest amount to £150,000. Suppose also that the business has incurred borrowing costs of £30,000. In everyday parlance we would say that the business has made a profit of £120,000. It is obvious why this should be the case – in calculating the profits we add up all the receipts and take away the expenses. Interest is an expense, so we deduct it.
But for tax purposes, it is not the same:
the profits of the property business amount to £150,000, because we are not permitted to deduct the interest in computing those profits;
however, the amount subject to corporation tax is £120,000, because we are permitted to deduct the net interest expense in calculating the taxable amount.
This is a subtle distinction. But does it really matter to anyone apart from tax experts? Surprisingly the answer is ‘Yes!’
Example 2: individual vs company landlord
The following table shows the profit figures for a property rental business for the financial years 2017 to 2019.
First of all, we shall assume that the business is operated by an individual landlord letting out commercial properties. In this case, there are no restrictions on tax relief for borrowing costs which (from 2017/18) only apply to residential property investment. Furthermore, the interest is immediately deductible in calculating rental profits, unlike the case for corporate landlords who have to relieve the costs separately.
2017 2018 2019
£ £ £
Property profits before
deducting interest expense 30,000 1,000 3,000
Interest expense (5,000) (10,000) (3,000)
Property profits 25,000 (9,000) Nil
In 2018, there is a loss of £9,000, which can either be carried forward, or set against current year income when the loss arises due to a capital allowance claim (ITA 2007, ss 118, 120). But there is no other income for the year and no profits in the following year to set against. It is not possible to carry back the loss into the preceding year 2017 and relieve it against the £25,000 profit.
Now consider the same figures and assume that we have a corporate landlord instead. This time the rental profits are calculated first, and only then can the interest be deducted:
2017 2018 2019
£ £ £
Property profits 30,000 1,000 3,000
Interest expense (5,000) (10,000) (3,000)
Profit after interest relief
(current year) 25,000 Nil Nil
Loan relationship deficit (9,000)
Interest relief (carry back) (9,000)
Taxable amount 16,000 Nil Nil
In this case, we have a £9,000 loss in 2018 as before. But the way in which this loss has arisen is important because the interest expense is treated separately, we can do the following (CTA 2009 Pt 5 Ch 16):
- for the year 2018, the first £1,000 of interest costs can be set against the current year profit of £1,000 – note that for tax purposes, the property business was actually in profit, bizarre though that may seem; and
- this leaves an excess of £9,000 available for relief. But this £9,000 is not a property loss, it is a loan relationship deficit, and because it is a loan relationship deficit, it can be carried back, unlike the property loss in the previous example (CTA 2009, s 459). The difference in treatment can clearly be seen.
So for commercial property, it turns out that the corporate landlord is treated more favourably than the individual landlord. The latter is unable to carry back the loss because the interest expenses are directly deductible in calculating rental profits.
For residential property investors, the position on interest expenses is changing. From 2017/18, only part of the interest is deductible as a business expense, with the balance being given relief at basic rate only after all the profits have been calculated (ITTOIA 2005, ss 272A, 274A). In this respect, there is a similarity with the loan relationship rules for corporate landlords. Unfortunately, any ‘excess’ under the new rules is not available to carry back as with a loan relationship deficit. So, once again, the corporate landlord is treated more favourably.
Using a company to invest in property has certain potential tax advantages over a direct investment. These advantages apply equally to commercial and residential property, and arise because of the specific rules which companies must follow in obtaining tax relief on their borrowing costs. Not only is relief normally available for the entire amount, but any losses which arise as a result of excess interest can be carried back to previous years. This is a facility not available to individual landlords.
This article was first printed in Property Tax Insider in October 2016.