by Adam Greaves
The Finance Act 1988 has extended the provisions of the Business Expansion Scheme (“the BES”) to investments before January 1 1994 in companies acquiring and letting properties on assured tenancies for the purposes of the Housing Act 1988 and equivalent legislation in Scotland and (when introduced) Northern Ireland. The intention is to encourage investment in the residential property market and increase the availability of private-rented housing, first by offering tax incentives to qualifying investors and, second, by offering landlords the opportunity to let residential property free from many of the constraints imposed by recent Rent Acts and landlord and tenant legislation.
It is estimated by BES commentators that over £100m has already been raised under public BES assured tenancy schemes launched last year.
Qualifying investors and companies
Under the terms of the BES a qualifying investor’s total income for tax purposes is reduced by the amount subscribed by him for ordinary shares issued by the BES assured tenancy company and relief is given at his top rate of tax, although relief cannot be claimed on more than £40,000 invested in any one tax year. Accordingly, an investment of £40,000 in a BES assured tenancy company will have an actual cost of only £24,000 after BES relief at the 40% tax rate. In addition, the investor will pay no capital gains tax on first disposal of his shares provided the qualifying conditions are satisfied.
The relief is available only to an individual tax resident in the United Kingdom who is not connected (for BES purposes) with the company and does not become so connected at any time during the period of five years from the date of issue of the shares. In particular, this means that neither the investor nor any of his associates for BES purposes can during the relevant period be a tenant, employee or paid director of the company or alone or together control the company or possess more than 30% of its ordinary share capital or voting power.
A company will qualify for BES assured tenancy purposes if throughout the period of four years from the date of issue of the BES shares it is incorporated and resident in the UK, has only fully paid shares in issue, is not quoted on the Stock Exchange or USM and exists wholly (or more or less exclusively) for the purposes of carrying on qualifying activities which it conducts on a commercial basis and with a view to profit. It must also not at any time during this period control any company (other than a 90%-owned assured tenancy company) or itself be under the control of another company.
Unlike the requirements for most other BES companies, all of the assets of an assured tenancy BES company can comprise land and buildings (ie the BES investment can be fully asset-backed) and it may, subject to certain limitations, raise up to £5m under the BES in any tax year (the normal ceiling is £500,000).
Qualifying properties and tenancies
Most unfurnished or furnished residential property in the UK will qualify provided it is habitable, does not have a market value and rateable value exceeding £125,000 and £1,500 respectively (Greater London) or £85,000 and £750 respectively (elsewhere). The property must not also have previously belonged to another company whose shares attracted BES-assured tenancy relief and must not, when acquired, already be let or be subject to letting arrangements and nor must it at any time be let by the company otherwise than on a qualifying tenancy.
To qualify, tenancies must be granted to individuals and must not be granted at a premium or at a low rent (less than two-thirds of the rateable value) and no option to purchase must be granted to the tenant or any associate of his. Certain types of tenancies are specifically excluded, including holiday lettings and assured shorthold tenancies within the meaning of the new housing legislation. A tenancy will not be eligible unless it is granted after January 14 1989 (England and Wales) or January 2 1989 (Scotland).
Rents can be freely negotiated at market rates, and during the contractual term can be changed only by agreement or agreed rent review procedure. After the contractual term and during any period of extended security of tenure only the landlord may instigate an increase of rent, although the tenant may appeal to a rent assessment committee which must fix it at a market rate, taking into account the availability of rented accommodation in the relevant area. The tenant has security of tenure after expiry of the original contractual term of the tenancy, but the landlord is afforded greater opportunity than previously enjoyed to regain vacant possession.
Who will benefit from the new legislation?
The beneficiaries under the new legislation will include qualifying individual investors, property agents and managers, builders and property developers and property investment companies.
Individual investors
Qualifying individual investors will benefit from the income and capital tax reliefs available under the new legislation and, in the smaller private schemes (or more ingenious public schemes), it may also be possible for the investor to claim tax relief on any interest paid on borrowings to finance his investment, provided the BES company is a close company for tax purposes, he acquires more than 5% of the company’s issued share capital, and that certain other conditions are satisfied. One implication of the tax relief afforded by the BES which is perhaps overlooked by many of the public issues is that there is no requirement under the BES for the tax-free capital gain to be exclusively referable to the BES activities of the company. After four years from the date of issue of the BES shares the company is free to carry on any activity it sees fit (including commercial property investment or development), and any gain in value of the BES shares realised from these activities will also be capital gains tax free.
Builders and developers
The amended BES rules offer an opportunity to builders and property developers to increase profit because of the additional finance available for purchase or refurbishment of residential properties. The qualifying company conditions will usually prevent building or development companies from raising finance themselves under the BES, but they can nevertheless promote their own BES companies (taking a significant but not controlling interest) and raise finance indirectly for their benefit. Because of the detailed requirements of the BES, it will also be difficult for the property enterpreneur owning or controlling the building or development company to claim BES relief on an investment in the BES company in these circumstances, although he could benefit from founder’s share or options, perhaps with performance-related rights.
Property agents and managers
The surge in BES assured tenancy activity will inevitably lead to sources of income for property managers or agents who will be retained to find or sell property to the BES companies, to let and manage and value the same and, on a realisation, to sell the property portfolios. Property agents and managers should also be well placed to promote their own BES-assured tenancy schemes in a manner similar to that outlined above.
Property investment companies
Property investment companies have the opportunity to promote and invest in BES assured tenancy schemes, provided steps are taken to ensure that the BES company is never under their control. They should also be in a position to acquire composite residential property portfolios on realisation by BES companies after their four-year qualifying period has elapsed. It is probably not practicable for property investment companies to raise money themselves under the new BES rules because their other property investments may well fall outside the requirements for the BES.
Establishing a BES assured tenancy scheme
The majority of BES assured tenancy schemes fall into the following categories: (a) small private schemes established by a few friends and contacts with only a limited number of properties in mind; (b) medium-sized schemes established by promoters who do not wish to incur the costs of a public BES issue (often referred to as private placings); and (c) the full public BES issue. Although the size of the proposed scheme will inevitably be dictated by the amount of money proposed to be raised, there are three further considerations which must not be overlooked — the costs of raising the money (the costs of a public issue can range from £60,000 to £250,000); the number and type of potential investors who may be approached without using a Companies Act prospectus or complying with the Financial Services Act; and the degree of management control that the promoters wish to have over the activities of a BES company and the timing of any realisation of their investment.
Statutory considerations
A prospectus and a public BES company will be required under the Companies Act where the BES shares are offered for subscription to the public (for these purposes there is no clear definition of “the public” but it would be prudent to assume that a public offer is involved where more than 25 people are approached). In addition, the detailed requirements of the Financial Services Act must also be observed in relation to the advertising and recommendation of the proposed BES investment.
Unless a private BES scheme involves only a domestic concern (ie a limited number of investors being family, friends and business colleagues) or a few selected professional investors investing for their own account, an authorised person for the purposes of the FSA and a prospectus will probably be required.
In practice, it is not difficult for newly established BES companies to comply with the prospectus requirements of the Companies Act provided proper professional advice is taken.
Most public BES issues are made using newly formed public companies which have not yet obtained a certificate to trade and borrow under section 117 of the Companies Act. Accordingly, such a public company should not enter into contracts for options to purchase property before such a certificate is obtained or unless the contracts or options concerned are conditional on such a certificate being obtained.
Small private schemes
The small private scheme will probably be established by four or more BES investors (not being associates in order to avoid becoming connected persons with the BES company). The ingredients will usually comprise a private company with suitable memorandum and articles of association (with pre-emption provisions, if required) and a shareholders’ agreement if the investors feel this to be necessary. Advice will probably be required from an accountant or solicitor to assist with the establishment of the scheme and in obtaining any advance clearance of the scheme from the Inland Revenue and to submit the BES relief claims. A friendly firm of estate agents may be engaged to assist in letting and managing the properties. It is now possible to purchase ready-made BES assured tenancy company kits specially designed for use in a small private scheme.
Private placings
The private placing will in many ways resemble a full public BES issue, although without much of the high advertising and marketing costs involved.
The documentation involved in a private placing will include an investment memorandum (approved where necessary under the FSA) or a prospectus, appropriate memorandum and articles of association depending upon the number of shareholders to be involved, formal agreements for engagement of key executives or consultants or property managers, contracts or options to acquire properties, and incentives for promoters or key executives (usually performance-related founders’ shares or options). Again, accountants/solicitors will be engaged to assist in the establishment of the scheme, to make BES clearance and BES relief applications, and to provide BES accounting and property advice.
Public issues
The style of a full public BES issue is reasonably well known, owing to the number of BES prospectuses which have already been issued both under the “old” BES provisions and the new assured tenancy rules.
A typical public issue will include many of the ingredients of a private placing referred to above. However, greater care is usually taken to provide comfort and safeguards for prospective investors to ensure that the promoters and their related companies are not receiving over-generous rewards and that any dealings between them and the BES company will be on an arm’s-length basis.
It is not usually possible to raise significant amounts of money under a full public BES issue unless a carefully planned and extensive marketing campaign is undertaken with the assistance of a sponsor or marketing experts and there is a good “product” to sell. Because of the number of public BES assured tenancy offers likely to appear in the period leading up to the end of the present tax year, it is unlikely that sponsors will be prepared to provide underwriting (and corresponding cover for start-up costs) unless the “property opportunity” being marketed represents an exceptionally sound investment in its own right.
Conclusions
It remains to be seen how long the public interest in the large BES issues will be sustained. One of the difficulties with the marketing of the larger public issues in the future will be the need to make the investment opportunity offered sufficiently different and attractive in its own right, with the availability of BES relief being incidental only. It is possible that many investors will find their own private BES schemes a more attractive alternative.
In any event, the BES assured tenancy provisions offer an opportunity for long-term tax-free capital gain which should not be overlooked.
