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Avoid the tax traps when investing in British property

Howard Bilton

South China Morning Post

9 May 2010

Hong Kong residents have long favoured property in Britain, particularly central London property, as an investment. Most weeks newspapers carry details of yet another new London development "pre-launching" in a nice hotel room in Hong Kong.

It seems selling to Hong Kong investors is a tried and tested method for financing new developments in London and there appears to be an endless appetite for such investments. Such purchases can seem all the more attractive partly due to the weakness of sterling and partly due to the prices, which fell in the credit crunch and have yet to surpass their historical peaks.

As with any other investment, failure to consider the tax implications and plan correctly can be costly, so here are a few things to consider.

Inheritance tax

Inheritance tax is the biggest issue for most investors. Those who are domiciled in Britain pay inheritance tax on the value of their worldwide estate. The first £325,000 (HK$3.78 million) is tax free but thereafter everything else is taxed at 40 per cent. Those who are not domiciled in Britain pay inheritance tax only on their assets in the United Kingdom.

What is often missed is that it is the total value of an individual's assets in Britain on which the tax is based. Let's presume an Hong Kong resident buys four flats in Britain for £250,000 each. Even if those properties do not rise in value at all between purchase and the death of the owner, the inheritance tax bill would be £270,000 - 40 per cent of £675,000.

The simplest way of avoiding this tax is to purchase the properties in the name of a non-British company. The asset owned by the individual is then the shares of the company, not the property itself. As long as the share register is kept outside Britain, the shares would not be considered a British asset and inheritance tax is eliminated. The other way to avoid the tax is for the family to use a good taxidermist and an electric rocking chair.

For investors domiciled in Britain, the shares of the non-British company (which will be worth the same as the value of the underlying properties) are still subject to the same 40 per cent tax, but carefully structuring the way the shares are owned can eliminate that too. So for Britain-domiciled persons living outside the United Kingdom, corporate ownership is probably still a good way to structure their investment. Certainly it allows subsequent transfers of the ownership to take place easily and cheaply by a transfer of shares, leaving the title to the property unchanged. This gives flexibility, which is absent with individual ownership.

Capital gains tax

Non-British residents do not pay capital gains tax so if either a non-resident individual or company sells an asset in Britain, there would not normally be any capital gains tax to be paid. This is unusual as most countries do charge capital gains tax on the sale of any asset located within their borders irrespective of who owns that asset. There is a trap here for the unwary.

If a property is purchased and sold quickly, there is a danger that the business of the owner will be assumed to be the buying and selling of property and the profits from that activity will be treated as income with a British source, not a capital gain, and will be taxable in Britain. If the property is purchased and then rented out for a number of years prior to resale, the business of the owner is assumed to be renting property and the sale is assumed to be an exceptional item. The sale is then treated as producing a capital gain. As capital gains made by non-residents are not taxed in Britain, the profit from the sale would generally escape British tax.

Income tax

Income from a trade or business carried on wholly within Britain will always be taxable in Britain. Rent generated on a British property is, by definition, income generated on a business wholly carried on within Britain, so that income is always going to be taxable in Britain irrespective of who owns the property.

If the property is rented, the owner must account for any income earned on the property. Tax is levied on the amount of rent earned less any expenses incurred to generate that rental income. Such expenses would include maintenance (but not improvements) insurance, all property taxes and, most importantly, the interest on any loan used to purchase the property.

Here lies another trap as it should be noted that theoretically, interest on a loan taken out after the purchase is not automatically deductible. Strange but true.

Deductions can also be made for flights to inspect the property and the expenses of maintaining any corporate vehicle which owns the property. The balance after all these amounts are deducted is taxable at 20 per cent.

Also note that interest on a loan from any source, including shareholder loans, can be deducted but only if the loan is made on fully commercial terms, that is on terms similar to those which could be obtained from a commercial bank. This would generally limit the amount of the loan to 70 or 80 per cent of the price and the interest should be competitive in the market place.

If a British resident director or other employee of the property-owning company lived in the British property without paying commercial rent, this may be considered to be a benefit in kind received by that director, and the individual would be taxed on the market rental value.

Anybody moving to Britain should avoid being a director because if the company is managed and controlled from Britain, the company will become British tax resident and have to pay capital gains tax.

Corporate ownership will normally be the way to go but there are many traps there as well. As always, consider all circumstances and get proper advice.

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