Tax and residential lease extensions

Mark Cawthron LLB CTA examines the tax implications of residential lease extensions and the changes to the tax reporting and payment rules for disposals of UK residential property

One of the features of life over the last 12 months or more has been that many of us have had the opportunity, or have felt it necessary, to devote more attention to our own financial affairs.

There has, it is reported, been a very large increase in individuals making Wills. Rather less mainstream but also finding its way onto people’s agendas – or at least the agendas of those who own flats – has been the subject of residential lease extensions. This partly coincides with anticipated legislative change in this area, following the Government’s announcement of prospective reforms made in January 2021.

This article looks at some taxation aspects of residential lease extensions. First, it briefly describes the general background and current state of play; advisers might find it useful to read about developments here – most advisers will have clients who in one form or other are flat owners!

Residential lease extensions – current property law

It is well known that many lessees under ‘long’ residential leases of flats have the right to purchase an extension of their lease. The right, as it applies in England and Wales, is contained in Part I of the Leasehold Reform, Housing and Urban Development Act 1993.

It used to be the case that to acquire the right to purchase a lease extension, the individual concerned had to occupy the flat as their residence. That rule has long been relaxed, and these days the requirement under the 1993 Act is that ‘the tenant has for the last two years been a qualifying tenant of the flat’. Flat owners holding the common form of long lease (which might originally have been granted for say 99 or 125 years) will, generally, be qualifying tenants.

The 1993 Act then states (at s. 56) that where such a qualifying tenant gives notice of their claim to extend:

• the landlord is bound to grant (and the tenant bound to accept) a new lease in substitution for the existing lease and on payment of the premium under the statutory formula (and of relevant costs).
• such new lease shall be at a peppercorn rent for a term expiring 90 years after the term date of the existing lease. So if a lease has 60 years left to run, the new lease will take the term up to 150 years.

The eventual cost of the new lease will be the premium plus the landlord’s reasonable costs (in addition to any professional costs the tenant incurs in the process). The landlord’s costs will likely extend to surveyor’s and lawyer’s charges.

Landlords and their flat lessees may often reach agreement for a lease extension outside of the statutory process, in the knowledge that the lessee’s right to extend exists.

Calculating the premium

A rather perplexing aspect of the current lease extension regime is how the amount of the premium changes quite dramatically as the existing or ‘old’ lease falls below 80 years’ unexpired term. The Government-funded Leasehold Advisory Service offers a ‘lease extension calculator’, to provide what it calls an ‘indicative value range’ (with, it should be added, a number of disclaimers as to use of such service).

Let’s take the example of a flat in say outer London, with a current market value of £350,000 and fixed ground rent of £80 per annum, and with a lease expiry date of 28 September 2106 (so some 85 years or so hence). The lease extension calculator produces the following premium ranges for a statutory lease extension – listed in the table both for ‘85 years to run’ and where the lease term is taken to be slightly shorter:

It can be seen there is a big jump in the amount of the lease premium once the unexpired lease term falls below 80 years. The calculator points out this is the result of the operation of the concept of ‘marriage value’, as that concept is applied by the 1993 Act.

Government proposals for reform

In January 2021, the government announced a number of proposals for the reform of leasehold law in England and Wales. These proposals grew out of reports by the Law Commission, and in relation to lease extensions included:

• qualifying leaseholders to have the right to extend the term of their lease by 990 years with a zero ground rent. This very long term length sends out a clear message that the Government wants leasehold to be a right that can be enjoyed by tenants and their successors effectively in perpetuity.
• abolition of marriage value. The January announcement rather boldly stated ‘the government is abolishing prohibitive costs like “marriage value”’: it is understood that following the announcement the property world started considering whether such a measure could breach the European Convention on Human Rights.
• fixing the rates valuers use to calculate lease extensions, so as to reduce costs and provide more certainty. These are the ‘capitalisation rate’ (used to calculate a capital sum that reflects the value of the ground rent income stream which will be foregone) and the ‘deferment rate’ (used to calculate a capital sum that reflects the value of the right to have the property back at the end of the lease); historically, a third ingredient here has been ‘relativity’ (used to calculate the relative value of the existing lease against a new, longer lease – that is, ‘marriage value’).

This threat to marriage value, and the prospect of lower transaction costs, might have reduced the number of lease extensions currently and in the near term, as tenants who wish to extend their leases wait to see if the changes are enacted to their benefit. Of course, in some cases, tenants could suffer a loss if they delay extending their leases and the Government ended up retaining some form of marriage value.

In the Queen’s speech itself last week listing legislative proposals for the new Parliamentary session, these matters were not specifically mentioned – the only reference being to the separate issue of ‘ending the practice of ground rents for new leasehold properties’ in a ‘Leasehold Reform (Ground Rent) Bill’ – but the intent is certainly there.

Taxation of residential lease extensions

There are various ways in which a lease might be ‘extended’. One such is to expressly surrender the existing lease and grant a new lease in its place. Equally though, if the term of an existing lease is simply expressed to be extended, such a ‘variation’ of the lease is also regarded, as a matter of property law, as an effective surrender of the old lease and grant of a new lease for the longer term. (Other approaches, which create a new lease to sit alongside the existing lease, and where the analysis is different, are not considered further in this article).

A number of tax aspects arise in connection with such lease extensions. These include:

1. tax on gains for the freeholder;
2. tax on gains for the flat owner, at least for those flat owners who do not occupy their flat as their (main) residence;
3. where the freeholder is a company whose shareholders comprise the flat owners, possible income tax liability on receipt of a lease extension.

The various provisions relating to SDLT, or LTT in Wales, need to be considered – for example the 3% (4% in Wales) additional rate charge (though this bites only where the chargeable consideration on the transaction is at least £40,000).

It’s worth noting here too that, from 6 April 2020, the tax reporting and payment rules changed for disposals of UK residential property. A taxable disposal by both UK resident and non-resident sellers has to be reported and CGT paid within 30 days from completion of the disposal. This is discussed further below, but first we briefly run through these main taxation consequences for freeholder and flat owner.

Tax on gains for the freeholder:

On the basis that the normal form of lease extension will anyway involve a surrender of old and grant of new lease, the freeholder (and it will normally be the freeholder, though could be an intermediate ‘head lessee’ if there is one) is making a ‘disposal’ out of their freehold interest, by way of granting the new (extended) lease.

Such disposal may very well incur a liability to tax on gains, albeit in most cases perhaps a small one. This should be calculated under the CGT ‘part disposal’ rules (with TCGA 1992, Sch. 8 setting out various provisions here). The ‘roll-over relief on compulsory acquisition’, in TCGA 1992, s. 247, can be available in such cases (HMRC Statement of Practice, SP13/93, refers).

If the freeholder is a company and the flat owners are the shareholders in the Company, the disposal by the Company would likely be based on a ‘market value’ consideration, irrespective of whether shareholders actually pay or not for their lease extension.

Tax on gains for the flat owner:

Flat owners may find that in principle they fall to be charged to tax on gains, again because of the property law analysis that the normal form of lease extension will in any event involve a surrender (and therefore a ‘disposal’) of the old lease. The consideration received for such surrender (and for payment of the premium) by the flat owner is the new lease.

Many flat owners will qualify for the ‘principal private residence’ (PPR) relief from CGT. For others, the idea that such a transaction might lead them to incur a liability to CGT seems a bit unfair – and HMRC accept this is so. In the Capital Gains Manual (at CG71240), reference is made to Extra-statutory concession ESC D39. First of all, there is confirmation that ‘the extension of a lease outside its original terms entails the surrender of the old lease and the grant of a new one. The surrender of the old lease is a disposal for the purposes of capital gains …’.

But helpfully, HMRC go on to say:

‘In practice, the surrender of an existing lease and the grant of a new lease should not be treated as a disposal for the purposes of capital gains if the taxpayer so wishes and all of the following conditions are satisfied:

• the transaction, whether made between connected or unconnected parties, is made on terms equivalent to those that would have been made between unconnected parties bargaining at arm’s length;
• the transaction is not part of or connected with a larger scheme or series of transactions;
• a capital sum is not received by the tenant;
• the extent of the property under the new lease is the same as that under the old lease;
• the terms of the new lease (other than its duration and the amount of rent payable) do not differ from those of the old lease. Trivial differences should be ignored.'

It is made clear that ESC D39 only applies to the lessee, it does not affect the lessor granting the lease extension (discussed above). CG71240 also goes on to set out the approach on any subsequent disposal of the new lease (although it must be said that it’s never really satisfactory to seek to deal with such ‘future matters’ outside of actual legislative provision).

Income distributions to shareholders:

Where the flat owners are also the shareholders in the Company that owns the freehold, a lease extension could, if they do not pay a ‘market value’ premium for their extension, give rise to an income tax liability for shareholders. This is because what would be an effective transfer of value out of the Company and into shareholders’ hands would seem to rank as a ‘distribution’ to shareholders, taxed in the same way as a cash dividend (this ignores any possible complication in the tax analysis where the shareholders are also directors!).

For this reason, in such a case it probably makes sense for shareholders to pay the ‘market value’ price for their lease extension (based on advice as to value from a surveyor), and for the Company to declare a cash dividend to return surplus (after expenses, including corporation tax liability, of the Company) to shareholders. This approach has the benefits of:

• getting (one assumes) within the terms of ESC D39 above, for those shareholders/flat owners who need to (and who might otherwise incur a liability to CGT on disposal of their ‘old’ lease);
• probably simplifying the completion of tax returns, where shareholders can more confidently report their cash dividend as the amount of taxable income (rather than reporting the value of what would be a distribution in kind, possibly without any surveyor’s prior involvement).

Tax reporting and payment

As mentioned, from 6 April 2020, we have an expanded CGT regime which requires very quick reporting of UK residential property disposals and payment of tax.

Finance Act 2019, Sch. 2 requires, subject to limited exceptions, a return to be made within 30 days of completion of the disposal. If a return is required, and ‘an amount of CGT is notionally chargeable’ in respect of the disposal, then a payment on account of CGT must also be made within the same 30 days. Paragraph 14(2) of the Schedule indicates that for this purpose one assumes the taxpayer has ‘made a claim or election, or given a notice [affecting the CGT liability] if it is reasonable to expect one will be made or given’.

Where does this leave the flat owner who extends their lease but is outside of PPR relief? Can they side-step Sch. 2 on the basis there is no ‘disposal’ per CG71240? Or that there is no CGT (notionally) payable? It isn’t clear though that the reference to claims, elections, notices above necessarily extends to the taxpayer seeking the benefit of ESC D39 (even if one notes that CG13700 refers to ‘claims and elections made under the Capital gains tax legislation and related Extra-Statutory Concessions’).

One might argue whether it is best – or indeed required, in order to comply with the statute – to make the return and pay the tax ‘notionally chargeable’, and then at the same time or perhaps later when the full Self-assessment return is delivered, ask for the benefit of the concession, to enable a repayment of tax. But that seems a very unsatisfactory outcome, even assuming the taxpayer is in a position to fund a payment of tax, pending later repayment.

Conclusion

It has always been essential for flat owners, where they can, to consider extending their lease in plenty of time before the unexpired term reduces to 80 years. In fact this approach seems to apply as much to flat owners who also own the freehold company, notwithstanding they have control over their situation – because of the tax issues outlined above.

There appears to be change afoot in the world of residential lease extensions. As well as being alert to the existing regime for lease extensions – in particular the calculation of the premium – flat owners on the one hand, and freeholders on the other, also need to consider how or whether possible legislative changes might affect their approach.

As regards taxation, Finance Act 2019 changes to the reporting and payment rules for UK residential property disposals must not be overlooked.

About the author

Mark Cawthron LLB, CTA, is a tax writer with Croner-i.