by Peter Steiner
At a time when the residential and commercial property sectors show only limited signs of life, and recovery in both sectors is some way off, it may seem a trifle churlish to have written (or to be reading, for that matter!) an article about the contrasting tax rules concerning options and conditional contracts.
Nevertheless, for those developers able to raise their heads above the still high interest battlements without fear of their bank manager taking aim, planning for the future is both a necessary and a prudent goal, since property development can involve a long gestation period. This can be particularly so where the development requires a planning permission (or a materially enhanced permission) that may prove to be difficult or controversial to achieve, or where the desired site is in many hands. In either circumstance, it may take some considerable time before the development can come to fruition.
For the developer, the attractiveness of both the option and the conditional contract, as opposed to an immediate acquisition, is his limited exposure, particularly in the case of the option. The chosen route (whether the option or the conditional contract) will, in addition to tax, be determined by several factors (including the relative bargaining power of the parties) beyond the remit of this article.
From the landowner’s point of view, taxation can be important in two ways when it comes to selling his land. While the amount of tax is significant, almost as important is its timing. In other words, when can the Inland Revenue demand the tax?
Except for stamp duty, this article concentrates on the landowner’s tax position, since the developer is assumed to be a property dealer (buying the land with the intention to develop and to realise swiftly his profit, in contrast to the landowner who has held his land as an investment), his expenditure being deductible for tax purposes against other trading income generated in the same year.
At the outset, it has to be said that the overall amount of taxation should be roughly the same for the landowner, whichever route is decided upon. Accordingly, he needs to consider whether any of his tax liability can be deferred significantly by one or other route.
Stamp duty
Stamp duty will normally be the developer’s liability, amounting to 1% of the option fee. If the option fee does not exceed £30,000, it seems that duty can be avoided by the use of a certificate of value in the agreement itself.
As a matter of practice, developers often choose not to pay the duty on the agreement, but to “wait and see” if they exercise their option subsequently. While stamping is necessary to enforce the agreement in the courts, it is possible to register an unstamped agreement against the landowner’s title (a) at the Land Registry, by means of a caution, in the case of registered land, and (b) at the Land Charges Registry, as an estate contract, in the case of unregistered land.
By contrast, conditional contracts are not stampable. Duty is payable on the transfer or conveyance itself, with one exception. That is when the conditional contract is an agreement for lease. In that case, duty is payable even though the agreement is conditional. As with options, developers entering into conditional agreements for lease often choose to “wait and see” as regards stamp duty, but nevertheless can register the agreement against the landowner’s title.
While stamp duty and value added tax liabilities need to be considered and (if relevant) appropriate action taken to mitigate them, neither is likely in practice to be so significant as capital gains tax (in the case of an individual landowner) or corporation tax (in the case of a corporate landowner).
The position of a landowner holding the land as an investment is considered below. However, it is instead possible for him to hold the land as trading stock. This could happen if:
(a) he acquired the land with the intention of selling it shortly thereafter; or
(b) he acquired it in order to obtain planning permission, and then to realise his profit by a sale; or
(c) he acquired it to derive rent income from it, but subsequently changed his intention and sought planning permission to obtain a substantial uplift in its value with the intention of realising his profit by a sale.
Although the question whether land is held as an investment or as trading stock is a technical one, the effect of the landowner holding the land as trading stock means that he will be taxed by reference to the year in which he receives a payment.
Options
From the point of view of tax planning, an option comes to mind, because for the purposes of capital gains tax in the case of an individual landowner (or corporation tax on chargeable gains in the corporate context), the time of disposal of the land itself can be delayed until the option is exercised by the developer.
Options can take two forms, the form more widely used being a “call option” granted by the landowner, whereby the developer can “call” for the land when he exercises the option, thereby forcing a sale. (“Put options” enable the landowner to, so to speak, “put” the land on to the developer and so force a purchase, but have the same tax effect.)
“An option is an asset for capital gains tax purposes, separate from the land itself.”
If the option fee is nominal (say, £1), or the option is granted under seal, then there is no immediate tax liability for the landowner. However, where the option fee is substantial (say, £100,000), then the landowner will normally pay 40% tax (25% to 33% in the case of a corporate landowner, depending on its overall profits in that year) by reference to the date when the option was granted. In capital gains tax parlance, the landowner will have “disposed” of the option for £100,000; he will not have “disposed” of the land, or even part of it. This follows from the concept of the option as an asset in its own right.
Individuals are liable to pay capital gains tax on December 1 in the tax year following that in which a disposal is made. (Companies pay tax nine months after the end of the accounting year in which a disposal is made.)
So, by way of example, where an option is to be granted by the landowner on April 5 1992 (the last day of the individual’s tax year 1991-92) for £100,000, tax will be due on that £100,000, less legal fees, agents’ commission and (in the case of an individual landowner) his annual exemption (currently £5,500) on December 1 1992. There will be no deductible acquisition cost, because the option will have cost the landowner nothing (being a separate asset from the land); instead, he himself will have “created” the option.
A deferral of the grant of the option by a single day, to April 6 1992, would defer the payment of tax by a year, to December 1 1993. This taxplanning point is, of course, relevant only if a substantial option fee has been paid.
As a matter of practice, the Inland Revenue does not normally assess taxpayers who have granted an option, if it is (a) of short duration and (b) for a relatively small payment, as compared with the eventual sum which will be payable on the option being exercised. The Revenue is content to “wait and see” if and when the option is exercised. The thinking seems to be: “Why do two calculations, if only one turns out to have been necessary?” However, the Revenue does have a discretion in deciding whether to apply this practice.
“On being exercised, the option and the land itself are merged for capital gains tax purposes, so that the capital gains tax treatment of the option as a separate asset disappears.”
The time of disposal of the land itself takes place on the date of exercise of the option, not when legal completion (the transfer, or the conveyance in the case of unregistered land) takes place. Any option fee previously paid is now treated for tax purposes as part of the price paid for the land. The effect is to cancel the tax treatment (if the Revenue had decided not to “wait and see”) of the option as a separate asset and to assess the landowner on all proceeds from the sale of the land, including the option fee. Any tax already paid by reference to the option will be available as a credit against the landowner’s “new” tax liability. If the Revenue has not taxed the option fee, it will be added to the purchase price of the land. The landowner will then be taxed in the normal way.
The above rules are not limited to a sale/purchase of freehold land. Similar rules apply in relation to an option to grant a lease where a premium is to be paid.
Conditional contracts
A conditional contract enables a disposal of the land to be deferred for tax purposes until the condition specified in the contract is fulfilled or waived. The landowner’s tax liability “crystallises” not by reference to when the contract is exchanged, nor to when completion takes place, but to the time when the contract becomes unconditional. For tax purposes, the condition must be “genuine” and this depends on the construction of the contract. The condition should normally be outside the control of the parties.
While dangerous to generalise, a contract dependent on the obtaining of planning permission is more likely to be conditional than a contract dependent on the obtaining of vacant possession where, for example, the landowner (or an associated company) is in occupation and can therefore determine when vacant possession can be given.
If a non-refundable deposit has been paid under such a contract, but the contract is never completed, then the landowner will be required to treat the forfeited deposit as if it were an option fee. He will be taxed on it as though he had granted an option.
Conclusion
If an option will be exercised by the developer only when a satisfactory planning permission has been obtained, then in practice there is unlikely to be any significant tax difference (whether as regards the amount or the timing) for the landowner between an option (to be exercised following receipt of a suitable planning permission) and a conditional contract (to become unconditional on receipt of a suitable planning permission) unless there is a substantial upfront fee payable.
In that case (namely, where there is a substantial upfront fee) the conditional contract is better for the landowner from the tax point of view, as he can retain the fee and pay no tax on it until the condition in the contract has been fulfilled. Otherwise, the choice of which route to take is likely to be made on commercial (and not on tax) grounds.
Peter Steiner, of Rowe & Maw, is a solicitor specialising in property taxation.
