Tax on sales of development land - opportunities and pitfalls

Despite the slowdown in the housing sector and the squeeze on developers’ margins there is still demand for land for development. For tax purposes, the sale of land for development can be complicated. In most cases the gain on the sale of land is chargeable to capital gains tax (CGT). However, in some cases the profit could be charged to income tax.

CGT treatment is usually preferable with tax rates at 10% or 20% for CGT purposes compared to income tax rates of up to 45%. Further, CGT treatment can provide additional reliefs, such as business asset disposal relief (BADR) and rollover relief. There is also the CGT annual exemption, currently £12.3K reducing to £6K from 6 April 2023 and £3K from 6 April 2024.

Where the proceeds of a qualifying land sale are reinvested into a new qualifying asset the tax on the sale can be deferred into the new asset. This effectively delays payment of tax until the new asset is sold. Qualifying assets include property used in a trade, such as farming. It also includes property let under the furnished holiday letting rules. The new asset will need to be purchased within either a year before the sale of the old asset or three years afterwards.

The difficulty with rollover relief is that, for full relief, all the proceeds from sale must be reinvested, which leaves little ability to retain cash for other use.

BADR halves the CGT rate from 20% to 10% for gains of up to £1M per individual over their lifetime, effectively a £100K tax saving per individual. Claiming this relief can be problematic, particularly where only part of a farm is being sold. Therefore planning for the sale well in advance is crucial to ensure the business structure, ownership, drafting of contracts and the timing of sale enables the relief to be maximised.

There are anti-avoidance provisions known as “Transactions in UK Land” (TIL) rules intended to catch profits generated from “trading in or developing land” by taking the profit which emerges as a capital gain and charging it to income tax.

These rules potentially apply to any disposal of UK land where one of the main purposes of acquiring the land was to realise a profit or gain from its disposal. As mentioned above income tax rates are significantly higher than CGT rates so the tax at stake can be huge.

It is common to see ‘slice of the action’ contracts that enable the landowner to share in the future proceeds of the developer. Typically, in these cases, the landowner would receive a fixed sum at the time of the land disposal followed by a percentage of the sale proceeds of each building subsequently constructed by the purchaser, under an overage clause. Therefore the landowner is able to share in the proceeds of the developer’s trading activity. Whilst the landowner is not himself trading, the conditions of TIL will be satisfied as land is being developed with the purpose of realising a profit from disposing of development land.

The sale of land can be dealt with under various contracts. Often land might be put into an option agreement or a promotion agreement. Both often have an upfront, nonrefundable payment to the landowner. The upfront payment is chargeable to tax in the tax year of receipt, but at that time no land is sold so there is very little cost to deduct before tax is charged.

The land sale often occurs once planning permission is obtained, on the exercise of the option agreement or once the promoter has found a successful buyer and contracts have exchanged. Under a promotion agreement the promoter will charge a fee, usually a percentage of selling price, plus VAT, for their services. The VAT cannot be reclaimed by the landowner unless there is an option to tax in place.

For tax purposes, the exercise of the option agreement is the tax point of sale, or the exchange of sale contracts on all other contracts. However, further complexities arise where contracts are ‘conditional’ on certain events taking place. For example, a sales contract might be exchanged, but the sale and purchase is conditional on an event such as planning permission. Depending on the precise wording of the contract this may delay the tax point of sale.

Many land sales also include overage clauses. For example, the sale price may be agreed based on a certain planning permission, or condition at the time of sale. However, the landowner may wish to benefit from any increase in value, after the land is sold, should the purchaser change the planning, such as from commercial to residential use which might increase the value of the land. Where an overage clause is included in the sale contract, the overage must be valued. Effectively on the sale the landowner receives £X plus the right to receive further consideration if the overage clause is triggered. The total consideration (£X plus the value of the overage) is charged to tax in the tax year the land is sold. If later the overage clause is triggered the landowner will receive additional consideration which will be charged to tax at that point, less the value of the overage previously taxed at the time of sale. The later overage consideration will not qualify for all the CGT reliefs mentioned above so careful consideration needs to be given to this at the point contracts are drafted. Further it is important to ensure the TIL rules are considered on the overage payment.

It is also important to consider the timing of receipts under the sale contract vis-a-vie the tax payment date. Often payments are made over a period of time, not on exchange or completion of the contract. Therefore it is important to ensure sufficient payments are received to cover the tax liability.

It is not uncommon for several landowners to ‘pool’ land to create a suitable site, signing up to a collaboration agreement. Often this entitles the landowners to a percentage of the total proceeds, based on the acreage of land they have contributed. These arrangements are complicated and can result in unintended tax consequences such as each landowner being taxed in full on the proceeds they receive for the sale of their land, with no deduction for the amounts paid to the other members of the collaboration agreement. The other landowners may however be taxed in full on the amounts they receive. For example, a landowner with a 20% share, receives and is taxed on £300K for the sale of an acre, with the gain taxable at 20%. The landowner makes a payment of £240K to the other landowners, on which they will also be taxed in full. There are a number of ways this double taxation can be avoided if advice is taken at the outset.

The sale of bare land is normally exempt from VAT, unless the vendor has notified HMRC of a valid “Option to Tax”. A key step in any transaction is to identify whether the land is Opted to Tax.

In some circumstances it can be beneficial to opt to tax the land as it will enable VAT to be reclaimed on related costs, such as a promotion fee.

If the purchaser is constructing new homes for sale (rather than letting) it will usually be able to recover VAT charged, although being charged VAT will impact on its cashflow. The contract should of course state that VAT is payable in addition to the agreed price.

If the sale is subject to VAT, the purchaser will normally suffer an increased SDLT charge, because SDLT is paid on the VAT-inclusive consideration. A purchaser being charged VAT may therefore wish to negotiate over the price.

An Option to Tax normally binds the person making it for at least 20 years. If the intended transaction is aborted, the Option to Tax will thus normally be in effect for any future transaction. Therefore opting to tax the land should be carefully considered.

This point also needs to be borne in mind if an overage payment, or a payment for agreeing to lift a restrictive covenant, is received at a later stage in relation to Opted land.

With so many complexities it is important professionals work together to ensure the aims of the landowner/s are met whilst maximising the net of tax proceeds.