by Richard Young and Graham Lee
Given the current downturn in the property market, what are the important financing and tax issues arising? As a generalisation, the downturn which has become evident in the residential — and more recently, the commercial sector — resulted from both oversupply and high interest rates.
Falling capital values
The spectre of falling capital values has resulted in an erosion of the quality of credit as perceived by lenders. The cutback in institutional finance, and particularly bank lending to new schemes, is now very apparent. Beginning in 1989, partly as a result of Bank of England concern, this cutback is now starting to bite as banks see it as a means of restricting oversupply of new developments, and thereby holding up the security values backing their existing property loan portfolios.
Banks, especially British banks, are taking a very wary view on financing new deals. They are concerned that they may be locked into existing development loans on completion as properties remain unlet or unsold, and therefore take the brunt of longer-term refinancing themselves. However, there is evidence that some bankers, notably foreign ones, are taking this as an opportunity to form relationships with property companies upon which they can build as the climate improves.
Impact on financial covenants
On existing development schemes the safety margin on loan covenants is eroding as a result of falling capital values and higher finance charges. Covenants can be specific to an individual scheme or to the company as a whole. It is the breach, particularly of the latter, that may cause banks to precipitate action. The function of covenants is to exert external financial discipline over the company and when breached they put the boot “on to” the banker’s foot, but not necessarily “into” the company. For developers liable to breach covenants, early consultation with bankers is recommended, as in many instances the breach may be technical and not a major concern. Alternatively, the breach could be serious, but nevertheless capable of resolution.
It may be possible to renegotiate key financial covenants, typically interest cover, gearing and aggregate levels of permitted borrowings, but probably only at the cost of higher interest margins or fees. Changes from the Companies Act 1989 in respect of the requirement to consolidate subsidiary undertakings, as redefined, may also mean revising existing loan covenants and the Articles of Association. For some borrowers it may be desirable to restructure existing joint venture arrangements, so as to avoid the requirement to consolidate. Control is the key feature, and it may be necessary to relinquish control if consolidation is to be avoided.
Structural engineering in finance
There are several ways to alleviate pressures on financial covenants, some of which will be appropriate only to certain borrowers. To help companies reduce the burden of interest rates there are a number of “low-start” schemes around. Some are promoted by commercial banks as a standard package, others are tailor-made by merchant banks and accountants, such as issues of deep discount bonds. Less attractive to investors now, but not necessarily impossible, are preferred shares.
The success of the preference share issue will depend on the pricing and the borrower’s ability to attract long-term investors. In the final analysis the cost of issuing preference shares may be more attractive than raising additional equity, such as a deeply discounted issue of ordinary shares. No doubt the “financial structural engineers” (the bankers, lawyers and accountants) will be working on solutions to these issues.
Finance schemes which involve spreading the default risk from bankers to insurers, where the top slice (say 10%) is covered by an insurance company, are well documented. Other schemes, sometimes involving insurers, which can help gearing typically by taking both assets and liabilities off the balance sheet — colloquially known as property “warehousing” schemes — are less well documented but can be suitable for investment companies. The essence here is that a property company sells its property to a bank, subject to a call option, to protect its downside, and the bank enters into put option arrangements which may involve a third party, such as an insurance company. These arrangements have been popular, although it will now be necessary to take account of the proposed successor to the accounting Exposure Draft 42 to find out what scope there will be for such schemes to continue to be off balance sheet in the future.
Another group of experts, the treasury specialists (perhaps the quantity surveyors of the financial world) are continuing to develop new financial instruments as well as dusting off some old ones. Over the past three years the enormous volume of interest rate swaps and options which have been taken on by property companies has no doubt helped to give them the benefit of continuing low long-term finance during this period of high interest rates. For some borrowers there is a breathing space. For many, however, the future looks increasingly bleak.
Inflation worries raising long-term funding costs
Worries over long-term inflation in the UK, the diminishing chances of the Conservatives’ re-election, and likely inflationary spillage from Eastern Europe to the West, have led to significant rises in long-term sterling interest rates (see diagram). Certainly these are approaching levels that make fixing interest rates unattractive. As a result borrowers have been turning to option-based products such as “caps”. It is likely with the current flattening of the interest rate yield curve (note, five-year money now is only some 1% below base rate) that we will see the return of “droplock loans”, which give the borrower funds at floating interest rate initially and then allow him to switch to a fixed interest rate once he is satisfied that rates have fallen far enough. Alternatively, when interest rates begin to turn down, borrowers may choose to do swaps where they receive fixed rates and pay floating rates — the opposite to what they have been doing over the past two years.
Prognosis
Overall, the immediate future is not good, with profits set to be hit hard and equity cushions under pressure, and not just in geared situations.
Since the new year, competing investor returns from the gilt market (especially in the medium term, two- to seven-year, period) have increased significantly, with yields up some 2% on average. This has caused a shift upward and a flattening of the interest rate yield curve for borrowers over this period. As a consequence it is not only developers but also property investment companies that will be hit. Profits will suffer as capital values have to fall in order to improve property yields, while at the same time the costs of financing, not just at the development stage but right out to the first five-year rent review, will have gone up considerably. With the full impact yet to come, however, now is the time to examine and come to terms with any necessary action.
Corporation tax issues
Faced with this situation, are there any tax issues which should be addressed? It would be misleading to suggest that corporation tax is the key concern in such a market. Maintaining activity or even ensuring business survival is plainly the primary goal. Indeed, reduced corporation tax liabilities might tend to suggest that tax is only a second order issue. However, the danger of neglecting tax consequences will be the wasting of tax reliefs which could have a cash value now or on a subsequent upturn.
Two areas where tax is relevant and advantages can be gained are
- relief for losses
- planning disposals.
These areas are considered below. In the first instance, however, it is important to appreciate a fundamental distinction in the taxation of property companies — the distinction between trading and investment activities. A company that is trading by dealing in property or by developing and selling property will be seeking relief under the tax rules relating to trading losses. By comparison, a property investment company may have a capital loss on the sale of a property investment or a loss due to interest payments which is relieved as a charge on income. Each type of tax loss has its own rules as to how it can be relieved.
Relief for losses
Consider the situation where a deficit has arisen from a reduction in property income or an increase in interest costs. What opportunities are available? The table summarises the way in which the losses of trading and investment companies can be relieved. Thus, a trading loss has the advantage of being available to relieve a profit of an earlier period and so may produce a cash repayment of corporation tax previously paid. When carried forward, however, it will only relieve profits of that same trade. An investment company cannot carry back its property or interest loss but has greater scope in the use of an interest loss carried forward.
A further difference with an investment company is that tax relief on loans is obtained on the amount of interest paid rather than on the amount charged in the profit and loss account. This may enable the company to control the timing of interest payments and hence tax relief to match suitable taxable profits. For this reason many property companies obtain an advantage from structuring their borrowing through an investment company in the group and make funds available to trading subsidiaries through inter-company loans.
Where companies have protected themselves from high interest rates through the use of interest rate swaps and options, the tax position can be more problematic. Without specific legislation to deal with these particular financial instruments it becomes necessary to try to apply general tax rules and rely on Inland Revenue practice. The result is a tendency to favour trading activities over investment ones. In this area, however, specific tax advice should be sought.
This brief summary suggests some planning opportunities. Property company advisers may need to review activities and structures and ask the following questions:
- Where are losses most likely to arise?
- Will immediate relief be available by current year offset or carry back?
- Can the current year use be improved?
- Where losses are carried forward will they be relieved at the earliest opportunity?
- Would an alternative tax strategy give greater certainty on the use of losses and more flexibility?
Planning disposals
Difficult times may require more drastic remedies. It may be necessary to dispose of some of the property activities to repay borrowing. These disposals may themselves give rise to losses which would be relieved as outlined above. Here it is intended to consider some of the options available in structuring a disposal which may secure an improved tax position.
The timing of a property disposal for tax purposes can be significant, particularly around the company year-end. It may be appropriate to ensure that a disposal giving rise to a loss occurs before the year-end or that one giving rise to a profit is deferred. There may also be advantages in matching the property disposal result with the tax position in the rest of the group.
The rules for trading and investment companies differ slightly on this matter. For investment disposals there is a statutory rule that the date of contract is taken as the date of disposal for CGT purposes. This is subject to the provision that, if a contract is subject to a condition (which can include the exercise of an option), the date of disposal is the time when the condition is fulfilled.
There is no statutory rule for trading disposals, although general principles have been established by case law. In most circumstances the accounting result will determine the tax result. Thus, the accounting policy on whether profit is recognised on exchange or completion will be relevant.
Capital allowance clawbacks
The sale of an investment property may involve a disposal for capital allowance purposes. The additional tax cost of a property disposal because of a clawback of industrial building allowances or plant and machinery allowances should always be considered. Industrial building allowances are given by reference to the original construction cost. The sale price will usually exceed this cost so that there will be a clawback of the allowances claimed by the vendor. However, for properties constructed after November 5 1962 no such balancing charge can arise after 25 years from the date of first use (previously the period was 50 years). Thus, mid-1960s industrial units may no longer be subject to a clawback of allowances.
Also, a balancing charge will arise only on the sale of the relevant interest. This is the property interest of the person who originally incurred the expenditure. A disposal of some inferior property interest would not give rise to a balancing charge. Thus, if the allowances had been granted to a freeholder on the construction of an industrial building, then the grant by the freeholder of a very long leasehold interest for a large premium would not trigger the balancing charge, although economically the transaction may be little different from a sale.
There is an increasing awareness of the plant and machinery content of offices and shops. Many claims have now been submitted either on the construction cost or on an apportioned purchase price. The sale of the property may also involve the recapture of these capital allowances. The recapture is limited to the allowances given, even if the property is sold at a profit. There may be circumstances in which a reduced disposal value can be used, although the effect on the capital gains computation also needs to be considered. A further factor to consider is the effect which any claim for allowances by the purchaser will have on the agreement of the disposal value of the vendor. The analysis of the various statutory provisions is not simple and where any significant figures are involved it could be worthwhile referring the matter to a property capital allowance specialist to consider the options available.
Company disposals
More complex property disposals bring their own more interesting tax-planning points. There is the possibility of selling a company owning the property rather than selling the property direct. This will require more negotiation between vendor and purchaser. However, if the vendor has a high capital gains base cost for his investment in the company there may be some advantage in deferring the CGT and capital allowance clawback liabilities arising on a straight property disposal. The rebasing of capital gains to values on March 31 1982 could be significant here.
Thus, with rebasing to 1982 values, even companies which have an original share capital of £100 may now have a capital gains base of several million pounds, taking account of indexation since March 1982 which has recently topped 50%.
Useful though this opportunity is for either outright sale or part sale to a new joint venture partner, there are dangers to be avoided. The tax legislation has long counteracted the tax-free transfer of an investment asset to a company and the subsequent sale of that company out of the group. Thus, when the company leaves the group there will be a deemed disposal by the company of the property, treated as taking place immediately after the property was acquired for its then value.
Although limiting, this particular piece of anti-avoidance legislation can at least be accommodated. Thus, no charge arises if the property transfer occurred more than six years prior to the company leaving the group. Even where a deemed disposal arises, it is by reference to the value of the property when it was transferred to the company, which may be several years previously. A charge based on a value four years ago may be an acceptable price to secure a company disposal now. There is no deemed capital allowance clawback on such a deemed capital gains tax disposal.
Finally, the use of a deemed market value rather than a sale price provides an opportunity for the company’s chartered surveyor to show his mettle and agree a satisfactory valuation with the district valuer.
Restructuring
The changes introduced by the Companies Act 1989 may entail the restructuring of direct or indirect interests in property. The general rules mentioned in this article will be relevant, although each case must be considered on its own particular circumstance.
Property “warehousing” schemes are examples of cases where accounting advantage may be tempered by tax consequences. The tax implications of triggering property disposals and establishing structures which may give rise to payments with restricted tax relief need to be fully considered to ensure that the cost/benefit balance is still favourable. Nevertheless, these arrangements may be worth considering, given restricted opportunities on other fronts.
Sale of losses
Finally, there is the question of whether any price can be extracted from the sale of the company for its losses or potential losses. There are anti-avoidance rules which apply to trading losses where, within a period of three years, there is a change in ownership of the company and a major change in the nature or conduct of the trade of the company. This makes the use of trading losses uncertain, so that payment is usually deferred until their use has been agreed.
There are no similar statutory restrictions associated with management expenses or capital losses. However, the Inland Revenue have stated that they would consider applying the Ramsay doctrine to purchased capital losses, thus denying their use to the acquirer. However, they have suffered a defeat for their view in the recent High Court case of Shepherd v Lyntress Ltd. That case is proceeding further so cannot be relied on yet. Nevertheless, the current climate suggests that, with careful management, it may be possible to secure extra benefit from such losses.
The position is considerably improved if the losses are only potential rather than realised at the date of sale. However, there are group relief provisions which could affect the calculation of loss available for surrender which arises after the company has been acquired. Subject to this, the realisation of the loss for tax purposes after acquisition should secure the best chance of use by the purchaser. This brings us back to the importance of timing in the realisation of losses.
Continued high interest rates and reduced demand in the property market will affect some property companies seriously. The management of this situation should include a review of the key tax issues. The reward for handling these issues effectively could be the receipt of handsome tax dividends, either currently or in the future when the recovery begins.
