Making light out of loss
Securing conditional tax relief benefits is never a straightforward undertaking. You could end up with more tax liabilities than you started out with, warns Brian Garner
The current economic climate, fuelled by various government incentives such as feed in tariff, is making many landowners consider entering into a renewable energy scheme. The goal is simple; to maximise the returns on their assets.
For those who are willing to take some commercial risk and be actively involved in the project, there are immediate and tangible benefits. However for those who simply want a secure income without direct involvement, there could be a sting in the tail. Renewable energy schemes must not be considered a safe, one-way bet.
Most landowners who decide to take the plunge choose to link up with developers and will usually consider the direct tax implications, such as income tax and VAT. Very few stop and think about inheritance tax however. Overseeing a renewable energy project will automatically increase the land's value but the project is likely to change the underlying nature and use of the land, thereby increasing the estate's exposure to inheritance tax. The result of such a project could therefore be better cashflow today, but an increased inheritance tax liability on death or gift in the future.
Speed read
Placing a renewable energy project on agricultural land could be a double edged sword.
Land value will increase but a project could store up inheritance issues in the future.
Being involved in the day to day running of the project may provide a good income and an inheritance tax shelter.
There are many other tax and legal issues that need to be considered, as well as inheritance tax.
Families may assume that by setting up a renewable energy project on their estate, they are protecting inheritance for future generations and safeguarding assets that may have been in the family for years. However if the project is not conducted and managed properly, it could in fact have the opposite effect.
Individuals need to be aware that instead of passing down farmland, potentially inheritance tax free, inheritance tax will become payable as the land becomes an investment property from which a rental income is derived, rather than as land used solely for agricultural purposes. This could lead to tax at 40 per cent becoming due on the value of the land upon death or gift. This cost would have to be met from outside of the estate or from external beneficiaries, which could place undue strain on the family's overall resources.
The inheritance tax position
The value of land, including any structures owned on the land, is potentially subject to inheritance tax at 40 per cent on the death of, or gift by, the landowner. However, there are two key reliefs that can potentially mitigate this tax liability, possibly down to 0 per cent.
The first relief is Agricultural Property Relief (APR) which may be available if the land is used for agricultural purposes. APR only applies to the agricultural value of land. Agricultural land which has additional value through development may therefore still be exposed to inheritance tax, if no other relief is available. APR is the relief which most farmers would rely upon to avoid inheritance tax on death or gift.
The second relief is Business Property Relief (BPR). This is available if the land is used in the landowner's business. There are several other conditions that need to be met in order to secure BPR, but the main one to note is that HMRC will not accept a claim for BPR if the activity in question is "wholly or mainly that of making or holding investments".
In this context, 'mainly' is considered to be more than 50 per cent, against various measures such as income. This therefore prevents most land or property that is let to third parties from qualifying for BPR, as the source of income will normally only be rental income.
It is possible for a landowner carrying out the business of generating and supplying electricity, through a renewable energy project for example, to claim BPR on the full value, including any development value, of the assets used in their business. This would include the land on which the business is situated, as long as the landowner passes HMRC's 'mainly' test.
The issue that arises is the question of whether the landowner is involved in the day to day running of the business, or whether his activities are really that of a landlord in receipt of rental income. The former will potentially pave the way for a claim for BPR, while the latter will mean that the land ceases to be either an APR or BPR asset for inheritance purposes. The answer to this question will normally be found in the agreement between the landowner and the developer.
The badges of trade – a renewable energy project versus rental income
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What is the subject matter of the transaction(s)? – i.e. sale of electricity or receipt of rent?
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What was the length of the period of ownership? If electricity is sold there is no real period of ownership, but land on which rents are received will potentially be held for years.
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What is the frequency or number of similar transactions by the same person? Electricity will be generated on a regular basis while rents may only be receivable monthly or even quarterly.
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What was the source of finance for the activity? Electricity generation will normally involve the raising of some external finance, while land may be owned outright or subject to a long term mortgage.
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Is the activity related to another trade carried on? It is difficult to see how this would be relevant in deciding the trading status on a renewable energy project.
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Was supplementary work on or in connection with the property realised? Electricity generation would involve the landowner building a project, while rental income would arise without any work being carried out by the landowner.
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Did the underlying asset provide enjoyment or an income to the owner? Electricity as the underlying asset would be sold when generated, while in the case of rental income, the underlying asset is the land which is kept and provides an ongoing income.
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What are the circumstances that were responsible for the realisation? Electricity is as a result of building a project, while the rental income on land is as a result of holding an asset.
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What was the motive? Electricity was generated with a view to a sale, whereas the land giving rise to rental income is held as an investment.
Joint venture agreements
More often than not, the landowner will enter into a joint venture with a developer, usually for a fixed period of time and with an upfront agreement over how the joint venture will operate to cover areas such as capital contributions, and profit sharing arrangements.
The dilemma facing the landowner is that if he enters into a joint venture agreement that provides a straightforward rental amount, there is a guaranteed return for the landowner and a reduction in commercial risk such as lack of wind or sunshine.
This type of arrangement will carry a potential inheritance tax liability. On the other hand opting for the alternative of being actively involved in the business exposes the landowner to commercial risks, but does potentially provide an inheritance tax shelter.
There are other legal and commercial issues that will need to be considered before entering into any agreement. Proper professional advice is necessary to ensure that the parties are protected and that the agreements work in the manner envisaged. There are also tax implications of entering into a joint venture agreement, such as potential stamp duty land tax, the availability of capital allowances on the costs, income tax, VAT and capital gains tax.
Once the agreement has been implemented to reflect the risk and reward which the landowner is committing to, it is essential that the agreement is adhered to, as HMRC will, in certain circumstances, not only rely on the form of the agreement but also its substance.
For example, if the agreement states that the landowner will carry out regular checks on the plant and machinery, he must do this himself and not expect the developer to carry out the work. This could indicate that he was not actively involved in the business but just receiving a rental income.
What constitutes a trading business?
There is considerable case law on what constitutes a trade but the main criteria that must be considered are known as the 'badges of trade'. On the balance of events, you meet most or in some circumstances only some of the badges of trade, HMRC will consider that a trade is in existence.
Unfortunately HMRC will not provide any form of advance assurance that an individual is actively carrying on a trading rather than an investment business. The test and review of the badges of trade will therefore only ever be applied retrospectively, when a potentially chargeable event occurs.
As a result, the onus is on the landowner to take as many steps as possible to demonstrate that they have been actively involved in a commercial business, and not just collecting investment income. There is no specific list of factors, but common points within the badges of trade that HMRC consider would include the following:
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Who are the parties to the various contracts? If possible, ensure that the contracts for development, invoices and all operating costs are in the name of the joint venture. Additionally, the income generated (including any government subsidies) should be payable to the joint venture vehicle rather than to the individual parties to the joint venture.
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Does the landowner have active involvement in the strategy of the business? Meetings should be arranged at least annually between the landowner and the developer, to consider the business and review performance and forecasts.
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How is the income presented to HMRC? Prepare and submit partnership/joint venture accounts and tax returns.
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Is there anything else that can be done to demonstrate trade activity to HMRC? For example, registering the business for VAT and possibly PAYE where appropriate. A landowner could also register the trade with HMRC and start paying class 2 national insurance contributions.
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How much time is spent by the landowner on running the project? The landowner should keep a detailed diary of time spent on the business.
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Who is responsible for dealing with issues that arise in relation to the project? The landowner should provide their personal contact details for an emergency contact list and expect to be the first point of contact in an emergency.
There will continue to be grey areas, such as the position if a farmer places a renewable energy project in a field but still uses the field to graze livestock. It is highly likely that each case will be viewed on its own merits and the 'mainly' tests mentioned above will be applied. This type of situation will no doubt be the subject of litigation between HMRC and taxpayers in the future.
Conclusion
It is unlikely that many landowners will be willing to give up the security of a guaranteed rental income on fields, or to commit the time and effort to a new business venture.
Failing to do so may provide a secure income for little or no ongoing involvement, but would result in the land potentially becoming an asset chargeable to inheritance tax on death or gift.
However for those few who are willing to accept the commercial risk and dedicate their own time and capital to a renewable energy business, an inheritance tax shelter may be achievable, alongside a reasonable income that provides a good return on investment.
Brian Garner is a director of tax at Michelmores