Finance Bill

Written evidence submitted by the Association of Taxation Technicians (FB 39)

Subject: Clause 24 - Relief for finance costs related to residential property businesses

1. Executive summary

1.1. The proposed legislation is designed to restrict the tax relief on finance costs that landlords incur in relation to residential property to the basic rate of income tax. It does this by first disallowing a deduction in respect of the relevant finance costs in the calculation of a taxpayer’s taxable income before then allowing a reduction in their resulting tax liability by an amount equal to the basic rate of tax on those finance costs.

1.2. This has the potential to produce unintended consequences. These will be most dramatic where the landlord has only modest profits from that business as currently measured and relatively high borrowings and/or an entitlement to a state benefit such as Child Benefit.

1.3. This is because, by increasing the amount of taxable income from the letting of residential properties, it means that:

· the tax due on the property letting activity can exceed the actual profit arising, and that

· a 40% taxpayer who is in receipt of a state benefit (such as Child Benefit) may have:

o a tax increase not of the expected 20% of their finance costs but of more than 50% of those costs and

o an effective rate of tax of over 300% on their actual property income.

1.4. This submission suggests the introduction of a transitional capping provision to limit the impact of the restriction of tax relief on finance costs so that the legislation achieves the expressed objective without imposing penal rates of tax in the identified circumstances.

2. Background and introduction

2.1. Paragraph 1 of the Explanatory Note to Clause 24 of the Finance Bill states:

The clause introduces a restriction on the deduction of finance costs related to let residential properties and instead provides for a tax reduction for such costs by reference to the basic rate of income tax.

2.2. Paragraph 1.191 of the Red Book (HC 264) states:

The government will restrict the relief on finance costs that landlords of residential property can get to the basic rate of income tax. The restriction will be phased in over 4 years, starting from April 2017.

2.3. The above two references are wholly consistent with the Chancellor’s announcement in his Budget speech on 8 July 2015 when he said:

… we will retain mortgage interest relief on residential property, but we will now restrict it to the basic rate of income tax.

And to help people adjust, we will phase in the withdrawal of the higher rate reliefs over a four year period, and only start withdrawal in April 2017.

2.4. The consistent message from 2.1 to 2.3 above is that relief for finance costs (mortgage interest, etc) on let residential property is to be restricted to the basic rate of income tax. That same message is contained in the HMRC policy paper published on 8 July 2015 – please see: https://www.gov.uk/government/publications/restricting-finance-cost-relief-for-individual-landlords/restricting-finance-cost-relief-for-individual-landlords

2.5. Section 3 below provides a brief outline of the mechanics of Clause 24.

2.6. Section 4 below illustrates how the Clause 24 provisions have the potential to produce consequences that are significantly more dramatic than a restriction of the tax relief on finance costs to the basic rate.

2.7. Section 5 below outlines a potential solution.

3. Mechanics of Clause 24

3.1. Briefly stated, Clause 24 works by:

3.1.1. First disallowing the finance costs that would otherwise (as currently) be an allowable deduction in calculating the taxable profits of the residential property letting business and

3.1.2. Then allowing a deduction from the individual’s resulting total tax liability of the basic rate of tax on those disallowed finance costs.

3.2. The provision will apply from April 2017 and (as indicated in 2.2 and 2.3 above) the disallowance will be phased in. That phasing-in will disallow 25% of the finance costs in the tax year 2017/2018, then 50% in 2018/2019 and 75% in 2019/2020 before the whole amount is disallowed in the calculation of the taxable profits of the business.

3.3. Clause 24 also includes more complex provisions that apply in particular circumstances but in straightforward circumstances it is designed to substitute basic rate tax relief on the finance costs for relief on those costs at the individual’s marginal tax rate.

4. Unintended consequences

4.1. By restricting the relief for finance costs (as summarised in section 3 above), the legislation is introducing an additional distinction between the measure of a taxpayer’s actual financial profit ("actual profit") and their rental profit for tax purposes.

4.2. The phasing-in of the disallowance (see 3.1.1 and 3.2 above) provides some smoothing of the transition from the current basis of calculation of profits to the new basis but it cannot compensate for a potentially dramatic increase in the effective rate of tax when measured against the actual profit. This is particularly likely to arise where the property income profits are modest and the finance costs are relatively high. An example may assist:

Example One (2017/2018)

Ella has annual taxable income (as currently measured) of £1,000 from a single residential property. That calculation includes a deduction of £5,000 of mortgage interest. She also has an annual salary of £49,000 so she is a higher rate taxpayer.

The effective rate of tax on her £1,000 of property income is currently 40% - she pays £400 on her £1,000 of profit.

In 2017/2018, the 25% restriction on her finance costs will increase her taxable profits by 25% of £5,000, namely £1,250. That increases her tax liability by £(1,250 @ 40% =) 500 before the deduction of £(1,250 @ 20%=) 250 reduces her net increased liability to £250. So Ella’s net tax liability on her rental income becomes £650 (her original liability of £400 plus the additional £250 under Clause 24).

The additional tax liability of £250 initially looks sensible. It is the difference between 40% and 20% on the £1,250 disallowed element Ella’s mortgage interest.

In passing, it is worth noting that Ella’s actual profit of £1,000 has not increased so the real effect of Clause 24 in 2017/2018 is to increase the effective rate of tax on those actual profits of £1,000 from the current rate 40% to 65% (being £650 tax on a profit of £1,000).

4.3. Looking ahead to 2020/2021 when the full impact of the disallowance applies, the impact is rather more dramatic as shown by Example Two:

Example Two (2020/2021)

Ella’s actual property income and salary are the same in 2020/2021 as in Example One.

The 100% disallowance of her finance costs of £5,000 converts Ella’s actual profit of £1,000 into taxable profits of £6,000. This produces an additional tax liability of £(5,000 @ 40% =) 2,000 before the deduction of £(5,000 @ 20% =) 1,000 reduces her net additional tax liability to £1,000. Ella’s tax liability on her rental income is now £1,400 (being the original £400 plus the £1,000 due under Clause 24).

Again, the additional liability of £1,000 initially looks sensible. It is the difference between 40% and 20% on Ella’s £5,000 of mortgage interest.

However, as in Example One, Ella’s actual profit of £1,000 has not increased so the real effect of Clause 24 in 2020/2021 is to increase the effective rate of tax on those actual profits of £1,000 from the current rate 40% to 140% (being £1,400 tax on a profit of £1,000). Ella has a tax liability greater than the actual profit from the activity on which the tax is due.

4.4. As Clause 24 involves redefining an individual’s taxable profit, that has implications for the interaction of the tax code with those state benefits which are related to taxable income. Example Three uses Child Benefit to illustrate the point.

Example Three (2017/2018 with Child Benefit)

Jacob has exactly the same sources and amounts of income in 2017/2018 as Ella in Example One. The only difference in his situation is that he has a family and would be liable to the High Income Child Benefit Charge (HICBC) if his taxable income (before personal allowances) exceeded £50,000 – which it currently does not as his income is exactly £(49,000 + 1,000 =) 50,000.

The disallowance of £1,250 of Jacob’s mortgage interest in 2017/2018 increases his taxable income of £50,000 by that amount. By reference to the GOV.UK Child Benefit Tax Calculator, the HICBC for someone with taxable income (ignoring personal allowances) of £51,250 is as shown in the table below:

The impact on Jacob of Clause 24 in 2017/2018 will not therefore be the additional £250 shown in Example One for Ella but between £(250 + 131 =) 381 and £(250 + 393 =) 643 depending on whether he is liable to HICBC on between one and four children. Those figures equate to tax rates (rounded to exclude decimal points) of between 30% and 51% of the disallowed £1,250 rather than the expected 20%.

The effective tax rates (as a percentage of Jacob’s actual property letting profit) are £(400 +250+131) / £1,000 = 78% with one child and £(400 + 250+393) / £1,000 = 104% with four children.

Note: If HICBC was due in respect of more than four children, the resulting percentages in both Examples Three and Four would be higher.

4.5. With the full disallowance of finance costs in 2020/2021, the impact of Clause 24 is maximised as shown in Example Four.

Example Four (2020/2021 with Child Benefit)

Jacob has exactly the same sources and amounts of income in 2020/2021 as in 2017/2018 and his family circumstances are unchanged. However, the full Clause 24 restriction increases his taxable income for HICBC purposes to £55,000. The HICBC for someone with taxable income of £55,000 (ignoring personal allowances) is as shown in the table below:

The impact on Jacob of Clause 24 in 2020/2021 will not therefore be the additional £1,000 shown in Example Two for Ella but between £(1,000 + 548 =) 1,548 and £(1,000 + 1,637 =) 2,637 depending on whether he is liable to HICBC on between one and four children. Those figures equate to tax rates of between 31% and 52% of the disallowed £5,000 (very similar to those in Example Three) rather than the expected 20%.

The effective tax rates (expressed as a percentage of Jacob’s actual profit) are £(400 +1,000+ 548) / £1,000 = 195% with one child and £(400+1,000 + 1,637) / £1,000 = 304% with four children.

5. Commentary

5.1. The four Examples above demonstrate that although the Clause 24 provisions achieve the objective of restricting the rate of tax relief on finance costs to the basic rate (see Example One), they can in the process:

5.1.1. Create tax liabilities that exceed the amount of the actual profits from the residential letting income on which they are charged (see Examples Two and Four) - particularly where the borrowings are relatively high in comparison to the current measure of profitability; and

5.1.2. Create collateral tax liabilities because of the interaction with the HICBC such that:

5.1.2.1. The additional tax resulting from the Clause 24 provisions is not 20% of the disallowed finance costs but between 31% and 52% of those costs depending on the number of children in respect of whom a HICBC arises and

5.1.2.2. The adjusted tax liability on the residential property letting income could (see Example Four) be as high as three times the actual profit from the activity.

5.2. The possibility of an individual having a tax liability that is greater than the actual profit from the activity on which the tax is being charged is of particular concern in the context of an activity like property investment. The borrowing that gives rise to the finance costs will have been undertaken by reference to the law as it existed when the loan was taken out – at a time when there was no reason to anticipate this divergence between the measure of profitability for commercial and taxation purposes. Borrowings in respect of property acquisitions are necessarily of a long-term nature. They cannot be readily repaid so the introduction of the proposed restriction has something of a retroactive quality to it.

5.3. The prospect of upward movement in interest rates (not considered in the Examples) has the potential to increase the number of individuals who may be significantly impacted by the Clause 24 proposals.

5.4. It is reasonable to expect someone who is now (since 8 July 2015) contemplating the purchase of a residential investment property to take into account the restriction of tax relief on finance costs. However, there appears to be a strong case for some transitional provision over and above the phasing-in of the disallowance of finance costs so that individuals who had relevant borrowings before 8 July 2015 are not exposed to either:

5.4.1. An additional liability of significantly more than 20% of the disallowed finance costs; or

5.4.2. An effective rate of tax by reference to their actual profits approaching or indeed exceeding 100%.

5.5. The inclusion of such a transitional provision could assist residential landlords to assess their position, make necessary adjustments to their activities and if necessary withdraw from residential property investment in a structured and orderly way.

6. Summary

6.1. This submission identifies and demonstrates what appear to be unintended or incompletely considered consequences of the draft legislation.

6.2. It suggests that there should be a transitional capping provision to limit the impact of the restriction of tax relief on finance costs so that the legislation achieves the expressed objective without imposing penal rates of tax in the identified circumstances.

7. The Association of Taxation Technicians

The Association is a charity and the leading professional body for those providing UK tax compliance services. Our primary charitable objective is to promote education and the study of tax administration and practice. One of our key aims is to provide an appropriate qualification for individuals who undertake tax compliance work. Drawing on our members' practical experience and knowledge, we contribute to consultations on the development of the UK tax system and seek to ensure that, for the general public, it is workable and as fair as possible.

The Association has over 7,700 members and Fellows together with over 5,600 students.

September 2015

Prepared 18th September 2015