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KEY POINTS
- Property letting and the meaning of the word 'business'.
- The effect of the Tax Law Rewrite project.
- A review of relevant lettings case law.
- Will treatment of rental income depend on whether the landlord is a company?
- Is it the quality of the letting activity that is important?
Mr Scraggs has a property let out to students. They regularly break the telly and spill beer on the carpets. They get locked out and ring him up in the small hours of the morning asking if he can get them back in.
There has been flood, pestilence and obnoxious diseases at the property, not necessarily all at the same time, as well as unwanted guests who end up squatting indefinitely. When any of them leaves, items at the property mysteriously 'disappear'.
Is Mr Scraggs carrying on a business? 'You bet I am', he will readily retort. 'It's more hassle than selling dodgy second-hand motors. The rental income is earned by much hard work and time consuming effort and if that is not a business, what is?'
Is Mr Scraggs right? And why would he want to know?
The etymological chameleon
The whole problem with the word 'business' is that it means all things to all men. In a 1978 case not on tax matters, it was held that the word is an etymological chameleon: 'it suits its meaning to the context in which it is found'.
Well that is very helpful indeed — thank you very much for that assistance.
What this means is that, even between different taxes, we can quite easily find property letting to be a business for one purpose, and not for another. Perhaps this helps to explain the entirely contradictory remarks which are in certain decisions on the topic.
For example, in the American Leaf Blending case [1978] STC 561 it was said that: 'In the case of a private individual it may well be that the mere receipt of rents from property that he owns raises no presumption that he is carrying on a business'.
And yet in Salisbury House Estate Limited v Fry 15 TC 266 Lord Justice Slesser made the following remark: 'As it seems to me, every landlord who lets out habitually more than one house, or part of a house, may be said to be carrying on a business…'
If one is looking at a company with let properties, it will certainly be a lot easier to establish that a company is carrying on a business. That was what the American Leaf Blending case was all about and there is a presumption that any company which puts its assets to gainful use for the benefit of its shareholders is carrying on a business.
Even so, some recent Special Commissioners' decisions have been chipping away at the boundary line here, as we shall see in a moment.
The accountant
One situation in which this will be an important issue is if Mr Scraggs is registered for VAT purposes. In the early days of VAT, the case of D A Walker (decision number 240) concerned an accountant in Shipley who was VAT registered and he also had three semi-detached houses which were let out on furnished tenancies.
Each house was occupied by three or four persons each of whom had the use of his own room and joint use of common parts. Mr Walker collected the rents and maintained the properties externally.
The VAT tribunal held that the property lettings were a business for VAT purposes and as a result Mr Walker was within the partial exemption rules.
He complained that they were treated as investment income for income tax purposes and so how could the position be different for VAT, but all to no avail.
It may seem to be a great injustice for the legislation to be so two-faced, but the reason for this is that the word 'business' in the VAT legislation is a translation of 'economic activity' from the Sixth EU Directive, and the Directive states categorically that 'the exploitation of tangible or intangible property for the purposes of obtaining income therefrom on a continuing basis shall also be considered an economic activity'.
The Tax Law Rewrite project
If Mr Scraggs were to chance upon the rewritten income tax legislation relating to 'property businesses' (ITTOIA 2005, s 264), he would no doubt jab his pointed finger down on that very title and state in a raised voice that his letting must be a business because that is how the law itself describes it. What more proof do you need?
The rewritten legislation says: 'A person's UK property business consists of:
(a) every business which the person carries on for generating income from land in the United Kingdom; and
(b) every transaction which the person enters into for that purpose otherwise than in the course of such a business'.
That certainly makes it appear that property letting is a business and other property transactions outside that business also get added in for income tax purposes.
Unfortunately, the notes issued by the Rewrite Project offer no support at all to this interpretation. The old Schedule A legislation in TA 1988 was redrafted in 1995 so that income tax was payable on the profits of any 'Schedule A business' and it was specifically said that all businesses and transactions chargeable under the schedule were treated as entered into in the course of carrying on a single business.
It was a sort of deeming provision. There is not quite the same deeming provision in the rewritten legislation, but the notes contain the following statement: 'Second, the concept of the “property business” is to a certain extent an artificial one. Unlike the term “trade” it may not always correspond to an activity organised in a way that the proprietor would necessarily describe as a business. As such, the term has to cover:
- real businesses where the lettings are organised in a professional way;
- lettings which are not so organised; and
- casual and one-off transactions which may have very few qualities normally associated with a business'.
These notes themselves are a little strange in my view. They seem to say that the test for property letting to be a business is based on whether the lettings are organised as a professional activity.
I do not really know where they got that from; if you spend all week on it, you probably have a business? Not according to the Special Commissioners.
The ailing taxi driver
There was an interesting National Insurance contributions appeal case in 2002 on this same topic (Rashid v Garcia SpC 348). The taxpayer had been a taxi driver and had done other colourful things, but had to give up when he suffered a heart attack. He also had income from four properties and these were a mix of residential and commercial lettings.
The residential tenants were mostly those introduced by social security who tended to stay for only a few weeks or else they were students who stayed for only a few terms.
He wanted his property income to be treated as business income so as to give entitlement to pay Class 2 contributions. It was a nice change to have an individual arguing for a tax liability and the Revenue arguing against! If only HMRC would do that more often.
Actually, what he wanted was to secure better state benefits after he had to give up work. To this end, at the appeal hearing, he gave a lengthy statement setting out in great detail all the work he did on the properties, including a large amount of maintenance work, drafting advertisements, making credit checks, cleaning the common parts and maintaining the garden.
All this took quite a lot of time each week. Unfortunately his appeal failed and the Special Commissioner summed up as follows: 'Standing back and looking at all the evidence although I think that the case is near the border line in the end I am not satisfied that there is sufficient activity for it to constitute a business. In my view, it is an investment which by its nature requires some activity to maintain it, rather than a business'.
The loan company
The picture which one now sees slowly appearing is that the simple letting of property to tenants does not normally constitute a business for tax purposes, other than for VAT. A Special Commissioners' case which tends to confirm this impression is the Salaried Persons Postal Loans Limited case ([2005] STC SCD 851), which concerned a company which had been in the business of making personal loans, but which ceased that trade in 1995.
After that time it simply received rents from a property which it owned and these amounted to £7,000 per annum. The Special Commissioner held that the company was not conducting any business by receiving the rents, this conclusion being based on the fact that the letting was the continuation of the letting of former trading premises which had continued for nearly 30 years while the company was trading.
The tenant remained the same and there was little activity otherwise by the company. That was insufficient to justify treating the company as conducting any business at all.
Although this case concerned a company and historically it has always been thought that the activities of companies are much more likely to be treated as business activities, whereas those same activities conducted by an individual might not, the Special Commissioner cast considerable doubt on this analysis for the following reason:
'The distinction between individuals and companies made in American Leaf Blending was old-fashioned and should not be given weight since there are now entities which are taxed as companies without being companies (unincorporated associations), and entities that are companies but are not taxed as companies (limited liability partnerships).'
If the Commissioner's view on this point is correct, there will need to be some adjustment in our thinking on the topic.
For example, a company with an investment portfolio would normally be considered to be in business, although a private individual doing the same would not. It seems hard to imagine that the individual would, on the Commissioner's viewpoint, now have to be regarded as being in business and so does this signify that investment companies may not now be regarded as conducting any business? Personally I doubt it.
The impecunious lady
The tentative conclusion does not square up very well with the outcome of the 1925 case Thorn v Madden 1925 1 Ch 847. That was a landlord and tenant case and concerned a covenant not to use a private dwelling house for the purposes of any trade or business.
The tenant concerned was a lady who was living beyond her means, but unfortunately she was loth to downsize to a smaller property.
She therefore took in friends and acquaintances as lodgers and it was held that she was as a result carrying on a business at the premises in contravention of the covenant in the lease.
It will no doubt seem very odd that taking in a few lodgers on a casual basis was held to be a business in contravention of a covenant in a lease, but collecting rents of £7,000 per annum under a 30-year tenancy was not a business for tax purposes.
However, that is chameleons for you. They are very hard to live with.
Incorporation
So why does this all matter? One reason is that it is commonly suggested that an individual can incorporate a property letting activity with the benefit of TCGA 1992, s 162 capital gains tax rollover relief for the transfer of a business to a company.
It has to be, in this case, a business as a going concern, but that surely just means an ongoing activity, which it will be so long as the tenants do not all flee when they hear that a company will be the new landlord.
On this subject, the Revenue's Capital Gains Manual at paragraph 65713 contains the following rather unhelpful statement:
'It is a question of fact whether a particular activity does constitute a business. It is not easy to draw the line, but we would resist claims that the passive holding of investments or an investment property amounted to a business.'
This statement is perfectly fine as far as it goes and it seems fairly clear that the Special Commissioners would agree that holding one investment property to collect rental income does not amount to a business.
No doubt HMRC wanted to keep this statement in the manual within safe boundaries (as acknowledged by the remark about it being difficult to draw the line).
It might be thought that one property may not be a business, but if a person has streets of them so that he has to spend a great deal of time on the management of them that must amount to a business, especially if it is near enough a full-time occupation.
There is, however, not a lot of justification for this view in any of the cases which I have briefly reviewed above. Some people live off the income from investment portfolios, and may spend a lot of time reviewing the existing holdings.
That does not make it a business. Similarly, looking after streets of properties may just as easily be an investment activity and not a business.
It is certainly the case that the amount of activity involved in property letting is one of the matters taken into account in deciding whether or not it is a business, but there is no case which lends support to the idea that lots of activity simply because there are many properties held brings about a business, whereas less activity because there are fewer properties does not. It is probably more a case of quality rather than quantity.
By analogy, a corner shop selling groceries and open only 2.5 days per week is just as much a business for tax purposes as Sainsbury's. So it's not a question of how much you do that counts, and whether it takes all week, but more a question of what you do.
The retired medical practitioner
One of the most interesting cases on this topic has never been reported as such. It was a Special Commissioners' decision before these were publicly released, and a synopsis of it was published in Taxation on 3 May 1990 under the headline 'Business as usual' (see Related Links above).
The point at issue was whether an office block let out to commercial tenants constituted a business for inheritance tax purposes and, if it did, whether it was a business of holding investments. I
t will be appreciated that this two-step test applies only for inheritance business property relief, and for other tax purposes one is normally just identifying whether or not there is a business.
The office block was owned by a retired medical practitioner who used the top two floors as his private residence and the other floors were let out on licences to tenants who were still in medical practice.
There was a basement which comprised an x-ray room and a self-contained flat which was occupied by a housekeeper. The taxpayer employed a receptionist and the housekeeper and he also undertook to keep the waiting room and other common parts heated, lit and furnished as well as properly cleaned and (by custom) provided flowers and periodicals for the waiting room.
The Special Commissioner held that this was a business activity and furthermore it was not a business of holding investments.
He said: 'It is common ground that an investor may hold a portfolio of freehold and leasehold properties and where, for example, such properties are let on full repairing and insuring leases under the control of a professional managing agent there would be little doubt that such a portfolio amounted to the holding of investments.
'At the other end of the scale one finds an hotelier who lives on his own premises and manages his own hotel: he would not be looked upon as the mere holder of an investment.'
The Special Commissioner held that the present case was not in the nature of an investment activity and inheritance tax business property relief was duly given.
So there is another good reason for knowing whether you have a business or not, although you have to negotiate past the investment test as well.
Back to Mr Scraggs
I will not be popular for this view, least of all with Mr Scraggs, but it does seem to me that the simple holding of let furnished or unfurnished properties by an individual will not normally amount to business activity on his part.
Any tax reliefs attaching to businesses as such are therefore unlikely to apply. However, property letting where the owner is actively involved is very near the border line, as was acknowledged in the Rashid v Garcia case and so it does not take very much to transfer it from an investment into a business activity.
The key is to provide a little more than that which the average landlord provides. In the 1990 Special Commissioners' case, it was a housekeeper and a receptionist, and I would hazard a guess that either of these would have been enough to persuade the Special Commissioner that there was a business.
If Mr Scraggs were to have several let properties and were to offer cleaning and laundry services, and add the cost of that onto the rents, he might just about be home and dry.
No one can guarantee it as we are looking here at a question of fact which, at the end of the day, the Commissioner decides, but what we do know is that active property letting is never far from being a business activity and a little extra will go a very long way indeed.
Malcolm Gunn FTII, TEP is a consultant principally with Squire, Sanders & Dempsey. He can be contacted at mgunn@ssd.com
