Investing in properties through a trading company – Pitfalls

Business owners holding shares of trading companies are entitled to some generous reliefs, which can be restricted if the company is involved in substantial non-trading activities.

Investing in properties through a trading company – Pitfalls

This blog discusses the pitfalls of investing in properties through a trading company.

In this article we cover:
  1. What is a Trading Company?
  2. Pitfalls of investing in property through a trading company

What is a Trading Company?

The general definition of a ‘trading company’ is any company carrying on trading activities whose activities do not include substantial activities other than trading activities.

For activities, HMRC looks at what the company is doing, from selling goods, providing consultancy to holding investments. Trading activities are further defined to include activities carried on in the course of, or for the purposes of, a trade being carried on by the company and preparatory work followed by the commencement of trade. This clearly implies that if an activity does not meet one of these definitions, they are deemed non-trading activity, which will usually be clear when the company is involved in investment activities.

The tax legislation is not particularly useful for the meaning of ‘substantial extent’ as there is nothing in the legislation that defines it. Instead of the meaning of substantial, one needs to interpret the comments provided by HMRC and analyse tax cases where courts have made decisions.

HMRC regards substantial as more than 20%, which is measured against the following indicators:

Turnover: income received from non-trading activities

Asset base: the total value of non-trading assets the company holds in comparison to its total assets

Expenses incurred or time spent by management and employees on on-trading activities

Additionally, the company’s history is also important to decide if the non-trading activities have always been substantial compared to its trading activities.

Each company will need to be judged on its own merits, and no the above indicators are for guidance only.

Pitfalls of investing in property through a trading company

Business Asset Disposal relief (BADR)

To be eligible for business asset disposal relief (formerly known as entrepreneur’s relief), the company must be classified as a trading company, which means that it cannot engage in significant non-trading or investment activity. HMRC considers “substantial” to be more than 20%, as explained above. Where entrepreneurs relief is available, the CGT rate on the first £1million of capital gains arising from the sale of the companys shares is reduced to 10% (Instead of 20 percent). The cost of losing out on BADR because you held a few investments through the company may be very punitive.

You can also read our blog on Entrepreneur’s Relief – When Selling Shares or Winding-Up

Business Property Relief (BPR)

Business Property Relief (BPR) reduces the value of the relevant business property that is subject to inheritance tax (IHT) on a transfer resulting from the death or a lifetime gift. Depending on the type of asset, the value reduction with BPR is 50% or 100%. This means that the amount of IHT owed could be cut in half or eliminated completely. Unlike BADR, the test used to establish whether a company is an investment company for BPR is 50% (compared to 80%), so it is usually easier for shares to qualify for BPR.

Due to business property relief, shares in a trading company can usually be passed on free of Inheritance Tax if certain other qualifying criteria are met. If the company also has investments, the amount of business property relief available may be reduced, or the company may be completely ineligible for the relief.

You can also read about Business Investment Relief

Gift Holdover Relief

Gift relief is usually available when the shares of a trading company are gifted. With the help of gift relief, it is possible to defer the capital gains tax when the person receiving the gift sells these shares. If the company is non-trading, for example, holds significant investment properties, then the relief is not available on the transfer of shares.

You can also read our blog on Gifting Shares to Employees

Mortgage/Commercial Loan Availability

One of the major drawbacks of making a property investment via a trading company is that mortgages are expensive, choices are limited and have lower borrowing limits. This is because trading activities, in general, carry higher litigation and failure risks, which could make them hard to fund, and some lenders may simply decide not to lend. You won’t have many options when you make property investment via a trading company, and the higher rates and fees will certainly be a deal-breaker.

Trading Activity is Risky

Without a doubt, both trading and investing involves capital risk. Trading, on the other hand, has a higher risk because the chances of failure are high, some activities may carry legal risks that may jeopardise the assets the company holds if a case is brought against the company. Thus, it will be considered as one of the major pitfalls for property investment via a trading company.

Determining whether a company is trading and thus qualifies for BADR and/or Business Property Relief can be complicated. We would advise you to seek advice before making investment decisions through your company as it could affect your ability to claim these very valuable reliefs.

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