Economic impact – why real estate businesses are rethinking tax strategy

For our recent Real Estate 360 market outlook, we surveyed 200 UK property experts. More than 50% said recent tax changes were impacting decision-making for real estate investors. 80% also said rises in interest rates and inflation was ‘somewhat’ or ‘significantly’ impacting their business plans.  
 
Given the current economic climate and stark realities facing the property sector in today’s world of high inflation and rising interest rates, this sentiment is concerning but unsurprising. 

 

A difficult debt financing environment is impacting decision-making for both private landlords and property companies. We are seeing individuals with large property portfolios thinking about creating a ‘corporate wrapper’ to take advantage of tax relief available on company debt payment costs. Businesses are re-examining their debt structuring as rising interest rates impact the amount of finance debt relief they can use to reduce their taxable profits. Increasingly, lenders are also looking for a greater equity stake in property assets as a way of reducing their risk in debt financing. 

Economic challenges bring debt relief into the spotlight 

 Rising inflation is pushing up costs across the sector, bringing down profits for many and hampering ability to borrow. At the same time, interest rate hikes intended to tackle inflation are making borrowing more expensive. After falling in recent months, inflation rose unexpectedly in February to 10.4%, putting further pressure on the Bank of England to continue raising interest rates. A 0.5% interest rate increase in February was duly followed by a 0.25% rise to 4.25% in March, the highest level since 2008.  

 

 

 

Meanwhile, the jump in the corporate tax rate from 19% to 25% confirmed by chancellor Jeremy Hunt in his spring budget means more property companies are likely to be looking at proactive ways to manage their tax burden. 
 
The fallout on the UK property market from higher inflation and interest rates can be seen in several areas. These include weakening inward investment and spiralling operational costs that could force private landlords out of the property market.  
 
As seen in the data below, the number of households occupied by private renters in England steadily increased between 2000 and 2017 – from 2m to more than 4m. We would therefore have expected to see this trend continue, but figures have remained relatively flat since 2016, indicating that residential rental properties may be a less attractive opportunity for investors. This could be for several reasons. Over the last decade or so, the government has penalised real estate investors by introducing various tax changes – including the gradual introduction of a measure to restrict relief for finance costs on residential properties to the basic rate of income tax, which started in 2017.  These factors combined with the lack of supply and other non-tax policies have resulted in rents increasing. 
 
We can also perhaps attribute flatness in the market to the impact of the Covid-19 pandemic property sales boom. During this time renters became buyers and landlords took advantage of a strong sales market – perhaps deciding that with higher taxes and increased regulations on rental properties, it was the ideal time to sell.  

 

Income repatriation considerations

With higher UK corporation tax and interest rates, tax efficiency strategies focusing on the repatriation of income are another consideration for property investors. If higher borrowing costs reduce the appeal of external funding, this may increase tax incurred by companies therefore putting a strain on investor returns which would also have a knock-on impact on enabling new investment. 

More companies are impacted by debt relief restrictions

The combination of economic uncertainty and higher corporation tax has further shone the spotlight on the Corporate Interest Restriction (CIR) rule, as it now affects more businesses. Of course, CIR is one of a multitude of new rules and complex anti-avoidance legislation which have been introduced by the government in recent years in a drive to limit and target deductibility.

CIR was introduced by HMRC in 2017, to restrict the ability of large businesses to reduce taxable profits through excessive UK interest expense. The rule also brings the UK in alignment with other European countries. It should not apply if annual finance costs are less than £2 million per CIR group. 

When it came into effect in 2017, most property companies were likely to be less impacted by the CIR rule. Also, many property structures were offshore and, pre-April 2020, would not have been subject to UK corporation tax. However, issues arose for more businesses when the slump in real estate activity caused by the Covid-19 pandemic triggered a fall in profits. Low interest rates at the time made borrowing more attractive and the CIR rule became more significant as it provided a way to manage debt financing and reduce tax liabilities.  

However, the latest and 11^th consecutive interest rate increase by the Bank of England in February indicates that the number of companies with interest and finance costs above the £2 million de minimis CIR rule is likely to continue rising. The 30% cap on allowable interest and finance costs under the CIR rule could mean some businesses end up with larger tax liabilities.

While the intention of HMRC is to prevent excessive claims to reduce taxable profits, it is seen in some quarters as penalising businesses that rely on debt financing, including in the real estate sector.  

Restructuring considerations

Current economic uncertainty makes it even more important for companies and property investors to regularly review their debt financing and tax strategies – as well as keep an eye on changes to the CIR rule. 
 
The CIR rule aims to steer companies away from relying on excessive debt financing (particularly where sourced from shareholders) to reduce their UK liability and instead consider alternative forms of funding, such as equity financing. Again, this will have tax implications that each company should include in its decision-making. From the lender’s perspective, equity financing can give greater confidence that the borrower’s debt-to-equity ratio is at a manageable proportion, especially in an uncertain economic future. Of course, debt rationalisations have their own tax complications, and restructuring debt is not easy either. Any restructuring comes with additional consequences which must be thought through fully.  

Next steps 

For individuals, particularly those with large portfolios, putting their property interests into a company for tax efficiency is worth exploring – carefully. As well as providing possible tax efficiency, a corporate structure can offer flexibility in managing debt and gives legal protection for individuals through limited liability. But again, each action has a tax reaction to consider (including taxes such as VAT, Stamp Duty Land Tax, for instance). 
 
It’s also important to consider capital allowances for commercial and qualifying residential properties. With the Chancellor’s announcement in spring 2022, regarding capital allowances, qualifying investors may wish to bring expenditure forward on qualifying spend – which might put further pressure on funding considerations.  
 
The first step for all types of property investors thinking about how they structure their portfolios should be to undertake modelling of their commercial and taxation costs. This will help investors make a better-informed long-term assessment of all available funding options. 

To explore tax restructuring options, contact Riaz Farooqi or Michaela Norman.