The knotty problem of property income

The recent case of J Nott (TC4897) considered the question of whether letting from holiday cottages was property or trading income.

Such a case encompasses a lot of current HMRC focus on the status of property income and their aggressive approach to classify such income as being derived from property and not a trading activity.

On Mr Nott’s 2009/10 tax return he showed income from holiday accommodation, music and farming. The return was enquired into by HMRC and they concluded that the income from the holiday cottage was property income as opposed to income from a trade. Mr Nott appealed on the basis that his holiday accommodation operation was a trading activity and the losses should be offset sideways.

Occupation of the property

The First-tier Tribunal (FTT) was of the opinion that letting activity would only constitute a trade if the owner remained in occupation of the property and provided services substantially beyond those that would be provided by a landlord in accordance with BIM22001. Mr Nott argued that occupation was a very key factor as he was in occupation of the farm and therefore in his opinion he was effectively in occupation of the holiday cottage units. The Tribunal concluded, however, that the taxpayer did not occupy each unit of accommodation and to treat the farming estate as a single parcel of land was unduly artificial. The farming estate included a manor house which was rented out by the taxpayer and a cottage owned by his sister and two other residential cottages. Mr Nott lived in one of those cottages.

The hotel comparison and other ownerships within the farm

In the opinion of the FTT, it was unrealistic to ignore these other ownerships and it could therefore not be said that he was occupying a single parcel of land. There were a number of holiday cottages (or units) on his farming estate which he provided as holiday accommodation for periods typically of two weeks at a time and they were run as part of a trade. Units were made available with the option of a daily breakfast and/or cleaning service.

The FTT considered that the provision of breakfast and daily cleaning for an extra charge enhanced the main profit generating activity of letting out the units. The fact that there was optional daily breakfast did not swing the position has surprised many commentators as breakfast is usually optional in most hotels. It is the bed & breakfast activity (where again breakfast can be optional) that is considered to be a trade. The Tribunal addressed the question of whether the income from the holiday accommodation was property income or trading income. In this connection the FTT considered how Mr Nott’s activities could be distinguished from hotels or bed and breakfast which were accepted as treated by HMRC as a trade.

Level of service provided operations

The HMRC closure notice on Mr Nott’s appeal had confirmed that farming losses could be set against other income for class 4 NIC’s purposes but the losses from the holiday cottage complex could not be offset against other income. This view was upheld by the Tribunal. HMRC did question what was the activity giving rise to the income stream. What were the customers paying for? The use of the land or a package of services forming part of a trade? Emphasis was placed by the FTT on the level of any services offered by Mr Nott. There were additional recreational facilities such as a swimming pool but these were considered merely to increase the attractiveness of the cottages for letting purposes. It was considered that the breakfasts and cleaning services were merely incidental to the main profit generating activity of letting the units.

The Tribunal considered various cases in arriving at its decision including Sywell Aerodrome Limited v Croft 24 TC 126, and Griffiths v Jackson [1983] STC 184. The Judge considered the decision in CRC v Pawson’s Personal Representatives [2013] STC 976 was in connection to inheritance tax (IHT) business property relief (BPR) and therefore the case was irrelevant.

Any farm that has diversified into farm holiday accommodation will have to ensure that the services are similar to a hotel if the income tax loss relief and the IHT relief are to be achieved. The inclusion of breakfast not as an option is a serious consideration to help with tax efficiency.

The Tribunal conclusion

The conclusion in para 85 of the decision states:

"Having considered the additional services provided by Mr Nott, we consider that, while extensive, they are not such as to ‘change the whole picture’ in the words of Lord Greene in Sywell Aerodrome. They are in large part consistent with the services normally provided by a landlord of furnished holiday accommodation. We agree with HMRC that the recreational facilities offered are in substance features intended to increase the attractiveness of the Units for letting, rather than additional services. The breakfasts and daily cleaning which are offered for an additional fee are insufficient to change the profit derivation from the exploitation of property to a package of services comprising a trade."

The question has to be asked,  what is enough activity to change the “profit derivation from the exploitation of property” to a trade? Tax advisers must look at establishing services that exceed the “investment line” drawn by HMRC when there are not enough apparent services provided.

Interest on borrowings

The Nott case comes at a time when in the 2016 Budget HMRC are restricting the availability of income tax relief for interest paid by residential landlords. The furnished holiday letting borrowings are excluded from the new stricter regime of allowability of loan interest emphasising that there is a difference between the two types of property. The HMRC and Tribunal approach to property income appears contrary to those who consider that furnished holiday accommodation is extremely hard work. From a UK economy viewpoint many consider that farmers should be encouraged to provide holiday accommodation for the general income that this directly brings to the countryside. Also by providing holiday accommodation for the customers of other rural businesses such as restaurants, tourist activities and pubs. Holiday accommodation should be encouraged through favourable tax relief, especially with regards to BPR.

Diversification of farm

In addition to the benefits holiday accommodation can bring, farmers have been encouraged over the last few decades to diversify, to look to alternative land use and to be entrepreneurial in this regard. Many farmers have looked to furnished holiday accommodation which they would see as a trade. Also livery income which has been under close scrutiny by HMRC, although farmers see this as a trade. Many commentators would see this overall approach as an irony that the Government, who encourage farmers into converting property into furnished holiday accommodation etc, is now controlling the negatives of such enterprises for tax with regard to income tax loss relief as shown by Nott. This also highlighted with regard to the potential lack of availability of business property relief for inheritance tax as evidenced by Pawson and Greene.

20% Capital Gains Tax rate and tax planning

There is currently a lot of confusion and uncertainty facing the future of farmers with the EU Referendum and the general low profitability from farming as demonstrated by the number of Tribunal cases on farm losses, for example, Scrambler, Silvester, Erridge, French, etc. In addition, many of the overall farming activities have become investment businesses for tax purposes under the conditions of section 105(3), ie that overall the enterprise is mainly that of holding investments. In this regard the Balfour case gave guidance on what is an overall investment activity, as did the 1999 case of Farmer (Farmer’s Executors v IRC (1999)). There are big concerns of the growth of farm “investments” within any farming enterprise and the unforeseen tax negatives.

Ironically the 2016 Budget which announced the CGT reduction to 20% from 28% in the Finance Bill 2016 could be used to advantage where a farm has too many investments. To quote from the Chancellor’s statement: “Legislation will be introduced in Finance Bill 2016 to amend subsections 4(2), 3, 4 and 5 of TCG Act to reduce the 18% and 28% rates in those provisions to 10% and 20% respectively. This will be subject to exclusions for chargeable gains on disposal of residential property that do not qualify for private residence relief and receipt of carried interest. Provisions will make clear that a person can use any unused income tax base rate in the most beneficial way."

Overall trading business

2016 and 2017 could, therefore, be a positive time to pass down what HMRC would consider to be commercial property investment business to the next generation. It is still understood that furnished holiday accommodation does qualify for the capital gains tax reliefs of holdover and rollover. While simple commercial letting does not qualify for holdover relief or rollover relief, it would qualify now for the lower rate of capital gains at 20% and opportunities to sell commercial property or to gift such property to ensure that the main trading operation is an overall trading business, not an investment business, will be considered.

Many farmers might consider, for example, converting normal cottages into furnished holiday lets so as they can take advantage of these CGT advantages of holdover and rollover while these advantages still exist. This could include planning around passing to non-farming children.

How to achieve trading status

In reality, the politics of how a farmer/landowner has arrived at a furnished holiday letting situation should be put aside, and consideration of both occupation and services must be reviewed on the basis of how HMRC define these matters. A larger operation with somebody in occupation with the services of breakfast and cleaning clearly does have tax advantages.

The 20% rate of capital gains tax will also be extremely useful when the qualification for entrepreneurs’ relief cannot be achieved. When large elements of farmland will be disposed of for, say, development, and entrepreneurs’ relief and/or rollover relief cannot be achieved, there is no doubt that the farming community will be taking advantage of this 20% capital gains tax advantage from the Spring Budget speech on 16 March 2016. Moving forward, farmers will be selling land in circumstances that will not qualify for entrepreneurs’ relief. The 20% rate will raise tax opportunities as part of the planning.

Practical points

The next decade will see very difficult and challenging times for farmers and landowners. The Nott case highlights a negative HMRC approach to “property income” and all landowning farmers must review the structure of their business for tax protection. The recent Budget 2016 changes and recent Tribunal cases will give guidance for the restructuring of farm enterprises with holiday accommodation and other investment type property contained therein.

Julie Butler F.C.A. Butler & Co
Julie Butler F.C.A. is the author of Tax Planning for Farm and Land Diversification, Equine Tax Planning, and Stanley: Taxation of Farmers and Landowners.

Farming and Rural Business Group, July 2016