Spotlight 63 warning to landlords about hybrid partnerships

HMRC has published Spotlight 63 about property business arrangements involving hybrid partnerships. It said the scheme is used by individual landlords to avoid paying tax on their property income and to reduce capital gains tax and inheritance tax.

The announcement might not come as a surprise to many in the industry, as this type of arrangement seems to have become more popular since the changes to the landlord rules made personal ownership less attractive for higher-rate taxpayers.

And while the scheme was marketed for its tax benefits, many of these are questionable, as HMRC highlights.

What is HMRC’s Spotlight series?

The Spotlights, published on GOV.UK, provide information about schemes HMRC believes are being used to avoid paying tax. The series aims to warn people against using tax avoidance schemes.

What is Spotlight 63?

In Spotlight 63, HMRC draws attention to a scheme being marketed as a tax planning option available to individual property landlords to structure their property business.

Sometimes referred to as a hybrid business model, the arrangement claims to:

• Bypass mortgage interest relief restrictions allowing increased deductions for mortgage interest.
• Reduce the tax payable on profits generated by the property business.
• Reduce capital gains tax (CGT) payable when properties are sold.
• Reduce inheritance tax (IHT) payable on death.

HMRC’s view is the scheme doesn’t work. It said people who use these arrangements may have to pay more than the tax they tried to avoid, as well as paying interest, penalties and high fees for using such schemes.

How do the arrangements claim to work?

HMRC said the arrangements seek to avoid tax by allowing individual or joint property landlords to transfer their properties to a limited liability partnership (LLP) with a corporate member. The LLP then allocates profits on a discretionary basis to members.

The arrangements are claimed to work as follows:

1. The individual landlords or their family members, or both, set up a limited company.
2. The individual landlords set up an LLP alongside the limited company — the limited company is considered the corporate member.
3. The individual landlords transfer their properties to the LLP.
4. The members of the LLP (the individual landlords and corporate member) allocate the LLP profits to themselves on a discretionary basis to make sure:

• the individual members remain basic rate taxpayers
• the remaining profits are allocated to the corporate member

5. The corporate member claims a deduction for finance costs (such as mortgage interest) relating to the properties.

HMRC said the scheme advises landlords that the arrangement results in less tax being payable for several reasons, including:

• The landlords remain basic rate taxpayers meaning they are not impacted by finance cost restrictions.
• Calculating the capital gain using an uplifted base cost at the date the properties are contributed to the LLP reduces the CGT paid compared to using the original purchase and improvement costs, if the properties are sold.
• Business property relief (BPR) may be claimed in respect of a hybrid structure carrying on a property rental business resulting in no IHT being due if the landlords die.

HMRC’s view of the arrangements

HMRC said the scheme doesn’t work because the arrangements are caught by tax law including:

• Mixed member partnership legislation contained in Income Tax (Trading and Other Income) Act 2005, S850C and S850D.
• Disposal of income streams through partnerships anti-avoidance legislation in Income Tax Act 2007, Chapter 5AA, S809AAZA.
• Inheritance Tax Act 1984, s105(3), which means a property rental business is likely to be within the exclusions from BPR because it involves ‘making or holding investments’. (The use of the hybrid business model doesn’t change the availability of the relief here.)

What to do if you’re using this arrangement

If you’re using this or similar schemes or arrangements, HMRC advises you to withdraw from it and settle your tax affairs. You can do this by emailing HMRC at spotlight63@hmrc.gov.uk, who will tell you what further information they need.

And if you’re concerned about the schemes you’re currently using, you should also consider:

• Getting independent, professional tax advice
• Speaking to one of the tax charities, such as TaxAid

You can anonymously report tax avoidance arrangements, schemes and the person offering you them to HMRC.

What does this mean for promoters?

Scheme promoters must comply with the disclosure of tax avoidance schemes (DOTAS) legislation, ensuring that arrangements they’re marketing are disclosed to HMRC.

Promoters face a penalty if they fail to disclose a scheme to HMRC within five days of the scheme being made available or implemented. The initial penalty is up to £600 a day – but fines can increase to £1 million.

Our thoughts on Spotlight 63

At Churchill Taxation, we avoid anything that could be considered a scheme by HMRC. In today’s tax world, it’s important for tax advice to be tailored to the taxpayer’s individual circumstances. We’d therefore encourage our clients to consider carefully before putting any type of schemes in place.

And if you’re a landlord who has used a hybrid partnership and are concerned about Spotlight 63, now is a good time to review your structure. It’s important to understand the potential risks and decide whether you need to make any changes.