Share of Freehold – How to give the taxman a windfall by doing nothing.
09 Feb 2023
Lease Extensions, Real Estate, Residential Property
For the purpose of this article, let us assume Basil owns the freehold of a house called Fawlty Towers comprising 3 flats each let on a long lease.
The lessees Sybil, Manuel and Polly form a limited company Fawlty Towers Freehold Limited (“FTFL”) to acquire the freehold from Basil for £30,000 (i.e £10,000 per flat.) Suppose that by the time FTFL completed the freehold purchase, the flatowners have no appetite for any more transactions relating to the building, taking the view that they now own a “share of freehold” so “job done.”
The change of freeholder has NO effect on the length or provisions of a flatowner’s lease of their flat. When Manuel decides to sell his flat some years later, he learns that his lease term has not magically become any longer, and the Buyer insists that he gets FTFL to extend the lease.
The value of the freehold interest is essentially the aggregate value of the total ground rent income under the lease, plus the reversionary value. Where there is a significant time lapse between completion of FTFL’s freehold purchase and Manuel’s flat sale, there may well have been a substantial increase in the value of the freehold. The value of a flat let on a long lease is in the lease, NOT any share of the freehold.
It can be assumed that when FTFL bought the freehold, the lessees intended to extend their leases. As we can see from above, the cost of each lease extension at that time would have been £10,000.
If the reversionary value of Manuel’s flat at the time of sale has increased to, say, £28,000, then there is a potential tax problem. Manuel paid £10,000 of this value as part of the freehold purchase, but if FTFL extend the lease now for no additional premium, FTFL may be viewed by HM Revenue and Customs (“HMRC”) as granting a benefit to Manuel which, for tax purposes, may be treated as making a ‘disposal’ of value out of the freehold of £18,000, and a Corporation Tax charge may arise unless formal clearance is obtained from HMRC.
Where lease extensions are to be granted to participating lessees many years after completion of the purchase of a freehold, it is possible to make an application to HMRC to obtain a ruling that tax does not arise for the company or lessees. However, this can be expensive and time-consuming. FTFL would need to prove that it was the intention to extend the leases from the time they purchased the freehold from Basil.
If this is not done, FTFL may not have the funds to pay this tax bill, and the burden may therefore all on Manuel before the lease extension can be completed.
Had Manuel’s lease been extended following completion of FTFL’s freehold purchase no tax consideration would have arisen and this problem would have been averted, and Fawlty Towers would not be Faulty Towers.
For more information about freeholds or other property related matters, please contact Andy Finkel at firstname.lastname@example.org