Since late 2023, HM Revenue & Customs (HMRC) has maintained that financing the withdrawal of a positive capital account balance before incorporating a business constitutes a notifiable tax avoidance scheme under the Disclosure of Tax Avoidance Schemes (DOTAS) legislation. This stance has prompted scrutiny from Property118, which challenges HMRC’s interpretation and has taken the matter to the First-tier Tribunal (FTT) for resolution.

HMRC’s position and industry guidance

HMRC’s argument centres on the timing and nature of capital withdrawals prior to incorporation. However, Property118 highlights that this practice is supported by established industry guidance, notably from Lexis Nexis, which advises that business owners with substantial capital accounts in unincorporated businesses should draw down these funds before incorporation to avoid locking capital into share value.

More significantly, HMRC’s own Business Income Manual (BIM45700) explicitly states that a proprietor may withdraw both profits and capital introduced to the business, even if this necessitates substitute funding through interest-bearing loans. The interest on such loans is allowable as a deduction, provided the borrowing aims to supply working capital. HMRC acknowledges that interest restrictions apply only if the proprietor’s capital account becomes overdrawn, as detailed in BIM45705 onwards.

Recent HMRC views on mortgage liabilities

Property118 has also uncovered, through a Freedom of Information request, that HMRC holds an unpublished view suggesting that when a company assumes new mortgages to redeem pre-incorporation mortgage liabilities, these funds could be treated as taxable consideration under Capital Gains Tax (CGT) rules. This introduces further legal uncertainty for landlords considering incorporation where mortgages are involved.

Due to this ambiguity, Property118 currently does not recommend Section 162 incorporation for landlords with mortgages, pending clearer guidance on the tax treatment of mortgage liabilities. Their position emphasises that the underlying principles of incorporation remain sound, but HMRC’s interpretation conflicts with its own published manuals.

Critics and counterarguments

Some commentators argue that the close timing of financing capital withdrawal to incorporation is abusive, a view Property118 disputes due to the lack of legislative or manual support. Similarly, the practice of loaning funds to the company immediately after incorporation for rapid debt repayment is also challenged by critics but defended by Property118 on the same grounds.

Critics further claim that transferring only beneficial interest at incorporation breaches mortgage terms and that mortgage novation is the sole acceptable method. Property118 counters this by noting that taxation follows beneficial interest and that the Law of Property Act 1925 protects mortgage lenders’ interests even when liabilities are indemnified without their consent. They also point out that novation is scarcely mentioned in HMRC manuals and is rarely offered by mortgage lenders today.

Tribunal proceedings and implications

The First-tier Tribunal is expected to issue a ruling later this year. However, the losing party may appeal to the Upper Tribunal and beyond, potentially delaying much-needed clarity for landlords wishing to incorporate their businesses. This ongoing uncertainty frustrates landlords who seek to benefit from incorporation for legitimate commercial reasons.

HMRC’s GAAR Guidance Part D paragraph 2.2 recognises that taxpayers have a legislative choice in actions such as incorporating a business or choosing to borrow to invest in buy-to-let properties. This guidance emphasises that such decisions are legitimate options provided by Parliament, reinforcing the argument that incorporation is a recognised and lawful strategy.

What this means for landlords

Landlords considering incorporation should be aware of the current legal uncertainties, particularly regarding mortgage liabilities and HMRC’s interpretation of capital withdrawals. While the principles supporting incorporation remain valid, the lack of definitive guidance means that professional advice and careful consideration are essential before proceeding.

Property118 recommends that landlords with established portfolios and modest borrowing engage in detailed discussions to evaluate their portfolios and forecast outcomes under various scenarios. This approach helps landlords navigate the complexities and make informed decisions aligned with their long-term objectives.

A conversation worth having

For landlords contemplating selling, expanding, or restructuring their property portfolios, consulting with a Property118 expert can provide valuable insights. These conversations typically benefit those with established holdings who are reflecting on optimising asset performance in the coming years.

Source: Based on reporting from Property118

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