Income chargeable: flat management companies
The following article, issued in TB37M for October 1998, explains the treatment to be adopted in respect of service charges received by occupier-controlled flat management companies as from 1 April 1998.
Flat management companies: CT Schedule A - residential service charges
Section 42, Landlord and Tenant Act 1987 (LTA87/S42) provides that contributions to variable service charges (and to sinking funds) in respect of residential property should be paid into a trust fund.
Under the old CT Schedule A rules (which applied up to 31 March 1998), the Revenue (now HMRC) took the view that service charges received by flat management companies were normally within the scope of Schedule A notwithstanding the provisions of LTA87/S42. This was because the charge under old Schedule A was based on the receipts to which a landlord was entitled in a chargeable period - old ICTA88/S15 (1) 2. However, where service charges received by occupier controlled flat management companies were matched over a period of up to five years by admissible expenses, no Schedule A charge was normally imposed.
We have been asked whether the position has changed under the Schedule A rules introduced by FA98/S38 and FA98/SCH5. Under Schedule A, it is necessary to consider the profits of the Schedule A business (calculated, in the first instance, in accordance with Schedule D Case I rules and correct accountancy principles). As from 1 April 1998, residential service charges received by occupier controlled flat management companies will ordinarily be outside the scope of Schedule A since, under correct accountancy principles, it will not usually be correct to include in the computation of profits sums to which the landlord is not beneficially entitled.
Consequently, where an occupier controlled flat management company receives residential service charges for periods subsequent to 31 March 1998, such sums will ordinarily be received as capital in the landlord’s capacity as trustee (under LTA87/S42). Investment income arising on such sums held in a designated bank account will be chargeable on the trustee at the rate applicable to trusts (Section 42 contains an implied power to accumulate).
Rents receivable by flat management companies (such as ground rents - other than peppercorn rents) are outside the scope of LTA87/S42 and remain chargeable under Schedule A.
This article sets out the line the Revenue (now HMRC) will take for all flat management companies as from 1 April 1998 but no action will ordinarily be taken to disturb the treatment accepted on specific cases prior to that date.
Where a trust return has not previously been made by flat management companies of investment income arising from a fund within LTA87/S42 (or from funds otherwise specifically held on trust), the trustees will have the normal obligation to notify chargeability.
A further article in TB48 provides more detailed guidance on the scope of LTA87/S42, what trustees should do where it applies and what to do where it does not apply. For convenience this is reproduced below.
For more information about flat management companies see TSEM5700 onwards.
TB48: Trust implications of flat management companies, service charge funds and sinking funds
In TB37 we published some guidance entitled “Flat Management Companies: New Corporation Tax Schedule A - Residential Service Charges”. This article was primarily concerned with changes arising from the new Schedule A rules introduced by FA98/S38 and FA98/SCH5.
As the previous article made clear, Section 42 of the Landlord and Tenant Act (LTA) 1987 provides that contributions to certain variable service charge funds (and to sinking funds) in respect of residential property should be paid into a trust fund. Investment income arising to that trust fund is chargeable on the trustee at the rate applicable to trusts, or the Schedule F trust rate, as LTA87/S42 contains an implied power to accumulate.
Since the article was published we have received a number of inquiries about flat management companies and trusts created under LTA87/S42. In many flat management companies the LTA87 will not apply and so the tax treatment of the fund will depend on the general status of the fund. It has also become clear that there are some flat management companies holding funds on trust that have previously been dealt with under the CT rules that should no longer be dealt with in that way.
This article provides some more detailed guidance on the scope of LTA87/S42, what trustees should do where it applies and what to do where it does not apply.
Many tenants and owners of properties in the UK make contributions to management companies and various service charge funds or sinking funds. These funds pay for a variety of services and sometimes accumulate money for future repairs. Typically, residents of a block of flats will all pay a set amount each year into a fund. That fund will either pay for joint day to day running costs of the block, such as cleaners and minor repairs, or funds will be put aside to pay for future major expenditure such as a roof repair. Some funds may do both within one fund.
The charges may typically be paid to a management company that could manage just that block of flats or any number of blocks. Sometimes residents of a block will set up their own management company, residents’ association or trust to receive the funds and carry out the work. Sometimes the landlord/freeholder holds the funds and organises the work.
Scope of LTA87/S42
The LTA87 applies only to England and Wales. LTA87/S42 applies where the tenants of two or more dwellings are required under the terms of their lease to contribute to the same costs by the payment of service charges (as defined in LTA85/S18 (1)). Such sums paid, or the investments representing those sums, or income accruing thereon, are held by the ‘payee’ on trust to defray any expenses incurred in connection with service charge expenditure. Subject to such payments of service charge expenditure the funds are held on trust for the tenants for the time being. The ‘payee’ can be the landlord or any other person to whom the service charges are payable by the tenants under the terms of the lease. LTA85/S18 (1) states that service charge means:
an amount payable by a tenant of a dwelling as part of or in addition to rent -
- which is payable, directly or indirectly, for services, repairs, maintenance or insurance or the landlord’s costs of management, and
- the whole or part of which varies or may vary according to the relevant costs.
The relevant costs are the costs or estimated costs incurred or to be incurred by or on behalf of the landlord, or a superior landlord, in connection with the matters for which the service charges are payable (LTA85/S18 (2)).
If the landlord is an exempt landlord (as defined in LTA87/S58 (1)) then LTA87/S42 does not apply - see below.
Therefore for LTA87/S42 to apply:
- The landlord must not be an exempt landlord, and
- tenants of two or more dwellings,
- under the terms of the lease,
- must be required to contribute directly or indirectly for repairs, maintenance, etc., and
- those charges, or part of them, must be variable.
If any of those elements are missing then LTA87/S42 does not apply.
Typically there are two main types of fund to which LTA87/S42 applies:
- Sinking funds involve the long term setting aside of funds for major repairs and renewals. Over a period, the fund can grow to a significant size and generate substantial investment income.
- Service charge funds are funds where the intention is to cover only the routine day to day costs of maintaining the communal areas and paying for minor repairs and decorations. The service charges are reviewed annually and set at a level to balance the actual expenditure and leave a ‘no surplus - no deficit’ situation at the end of each year. In practise there may be a small amount held in reserve or carried over from the previous year. The trust will not accumulate any surplus charges or create any sort of contingency or sinking fund and any investment income is derived only from the short-term deposit of temporarily surplus funds.
Some trusts will act both as a sinking fund and as a service charge fund, although usually the trustees would keep the two funds separate.
What sinking funds or service charge funds are within LTA87/S42
There are a number of different situations in which sinking funds or service charge funds may be created. Not all of these will necessarily fall within the scope of LTA87/S42.
Tenants of rented property
Under the terms of a rental contract either the tenant or the landlord will be responsible for repairing the property. If the landlord includes in the rent payable some figure to cover his repairing obligations the fact that the payment by the tenant will be part of his rent will not preclude the operation of LTA87/S42. However, in order to fall within the definition of service charge the amount must be variable according to the costs or estimated costs of repairs etc. So if the lease simply states that part of the rents payable will be used for servicing, repairs and maintenance etc. for which the landlord is then responsible then the matter is outside LTA87/S42 because the payments by the tenants do not amount to a service charge as defined in LTA85/S18. The whole of the rent will be Schedule A income of the landlord.
Leaseholder owners of property
Under the terms of the lease the leaseholder may have to pay into a service charge fund or sinking fund. The funds may be paid to an individual, a company, a trust or an unincorporated association. As the owner owns the property under a lease, the LTA87 will apply. If the lease specifies contributions are to be made to a service charge fund or sinking fund then an accumulation trust exists whether the funds are paid to an individual, a company, a trust or an unincorporated association.
The body holding the funds may not consider themselves to be trustees, for example a company. However if LTA87/S42 applies then the company will be holding the funds as a trustee.
If the lease stipulates that tenants must pay a service charge for particular services to a service company which is not the landlord, connected with the landlord or stipulated by the landlord, this too is within LTA87/S42. In that Section ‘the payee’ is defined as “the landlord or other person to whom any such charges are payable by those tenants under the terms of their leases”.
If the lease states that the tenant should arrange for services, repairs and maintenance etc. themselves but does not specify how this should be done, any arrangement made by the tenants with a service company is outside the scope of LTA87/S42. The costs in respect of service charges are not made either to the landlord or to another person to whom such charges are payable under the terms of the lease.
Finally where there is no provision in the lease for the tenants to pay into a service charge fund, but nevertheless they decide to create one, then such an arrangement is not within LTA87/S42 as the tenants are not ‘required under the terms of their leases to contribute to the same costs by the payment of service charges’.
Freehold owners of property
Under the terms of sale of a freehold property (a covenant of some sort) the freeholders may have to pay into a service charge fund or sinking fund. The funds may be paid to an individual, a company, a trust or an unincorporated association. Such an arrangement does not come within LTA87/S42 as it is not under the terms of a lease.
Alternatively there may be no provision to create a service charge fund or sinking fund but the freeholders together decide to form one. They may decide to pay those contributions to an individual, a company, a trust or an unincorporated association. Again this is a private arrangement not governed by LTA87/S42 and the tax treatment depends on what the freeholders decide is going to hold the funds.
Registered social landlords (RSLs) and other ‘exempt landlords’
RSLs are, in England and Wales, independent, private sector, non- profit making bodies whose main purpose is to provide decent quality, affordable housing for people on low incomes. About three-quarters of them are charities.
LTA87/S42 does not apply to tenants of exempt landlords (LTA87/S42 (1)). In accordance with LTA87/S58 (1)(g) a RSL is an exempt landlord. There are other exempt landlords defined in LTA87/S58 (1) & (1A) such as district councils and certain development corporations. (LTA87/S58 (1) & (1A) is reproduced below.)
Whilst LTA87/S42 does not apply to RSLs and other exempt landlords, as explained below, the terms under which sinking funds and/ or service charge funds are held by exempt landlords may still create a trust.
Thus, in summary, reference must be made to the terms of the lease to determine the application of LTA87/S42. A statutory trust will arise where the tenants of two or more dwellings are required under the terms of their leases to contribute to the payment of variable service charges to the landlord or other persons to whom such charges are payable under the terms of the leases. However, LTA87/S42 does not apply where the landlord is an exempt landlord.
Funds not within LTA87/S42
Where a fund exists but it is not within LTA87/S42, for example where freehold owners of property decide to create a sinking fund, or because the landlord is an RSL or other exempt landlord, then the treatment of that fund will depend on what structure is used:
- Where an individual holds the funds: the individual could be an employee, trading as a maintenance contractor or they could hold funds as trustee for the freeholders. If the latter then the sort of trust depends on the terms of the trust, not on LTA87/S42.
- Where a company holds the funds: assuming the company was formed to hold funds for the freeholders who created it, then it could hold the funds as trustee. Alternatively it could trade as a flat management company receiving payments under a contractual arrangement to supply services and pay CT. The status of the fund will depend on the terms under which the payments are made and the terms under which the company holds the funds.
- Where a trust holds the funds: it could be any sort of trust depending on the terms of the deed but it would not be within LTA87/S42.
- Where an unincorporated association holds the funds: such as a residents’ association. It would be liable to CT unless it was acting as a trustee. Again any trust would not be within LTA87/S42.
Any funds held by trustees would be subject to the normal trust rules. It is possible for the funds to be held under a bare trust, interest in possession trust, discretionary trust or accumulation trust arrangement. The exact status will depend on the terms and nature of the trust agreement.
What trustees should do
As the TB37 article made clear, in the past some flat management companies have been permitted to make returns in respect of investment income, arising on service charge funds and sinking funds, as part of their CT returns. That is no longer appropriate where trustees hold funds as trustees under LTA87/S42. Likewise where LTA87/S42 does not apply but the terms under which the funds are held creates a trust.
Trustees should write to the appropriate trust office, address below, enclosing a completed form 41G (Trust), or providing the following information for each trust:
- The full title of the trust fund.
- The names and addresses of the trustees.
- The name and address of any professional agents acting.
- The date the trust was established under the terms of the lease.
- The existing CT reference, where appropriate.
- The gross amount of any investment income received each year that has not been included on a CT return.
- Whether the trust is a sinking fund, service charge fund or both as outlined above.
As the October 1998 article made clear, rents receivable by flat management companies (such as ground rents - other than peppercorn rents) are outside the scope of LTA87/S42 and remain chargeable under Schedule A.
The TB37 article explained the approach the Inland Revenue (now HMRC) will take for all flat management companies as from 1 April 1998. However, because of the need to issue this further guidance, no action will ordinarily be taken to disturb any year or accounting period for which a CT return has already been made and accepted. Where a trust return has not previously been made by a flat management company, or a trustee, of investment income arising from a fund within LTA87/S42 (or from funds otherwise specifically held on trust), the trustees will have the normal obligation to notify chargeability.
Section 58 (1) and (1A) are reproduced below. They define exempt landlords for the purposes of the LTA87.
(1) in this Act “exempt landlord” means a landlord who is one of the following bodies, namely -
(a) a district, county or London borough council, the Common Council of the City of London, the Council of the Isles of Scilly, a police authority established under section 3 of the Police Act 1996 or a joint authority established by Part IV of the Local Government Act 1985;
(b) the Commission for the New Towns or a development corporation established by an order made (or having effect as if made) under the New Towns Act 1981;
(c) an urban development corporation within the meaning of Part XVI of the Local Government, Planning and Land Act 1980;
(ca) a housing action trust established under Part III of the Housing Act 1988;
(dd) the Broads Authority;
(de) a National Park Authority;
(e) the Housing Corporation;
(f) a housing trust (as defined in section 6 of the Housing Act 1985) which is a charity;
(g) a registered social landlord, or a fully mutual housing association which is not a registered social landlord; or
(h) an authority established under section 10 of the Local Government Act 1985 (joint arrangements for waste disposal functions).”
(1A) In subsection (1)(g) -
“fully mutual housing association” has the same meaning as in the Housing Association Act 1985 (see section 1(1) and (2) of that Act); and “registered social landlord” has the same meaning as in the Housing Act 1985 (see section 5( 4) and (5) of that Act).
For current information about trusts see the Trusts, Settlements and Estates Manual.