Why ownership, valuation and market value need to be checked before extending a lease

If you own a flat with a share of the freehold, extending your lease to 999 years and reducing the ground rent to a peppercorn can seem like little more than an administrative exercise.

After all, if the leaseholders effectively own the freehold between them, why should anyone have to pay for a lease extension?

And if no money changes hands, surely there can’t be any tax?

Unfortunately, it isn’t necessarily that simple.

A lease extension can potentially create tax consequences even where the leaseholder pays nothing.

The key questions are:

• Who actually owns the freehold?
• Does a company own the freehold beneficially, or is it merely holding it as nominee for the leaseholders?
• What is the existing lease worth?
• What is the extended lease worth?
• What is the freeholder’s reversionary interest worth?
• Is value being transferred from the freeholder to the leaseholder?
• Are the parties connected?
• Is the transaction taking place at market value?

These questions should be answered before the leases are extended, not afterwards.

Let’s look at why.

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Why Extend a Residential Lease?

Many blocks of flats have a structure where the leaseholders collectively control the freehold, often through a residents’ management or freehold company.

The individual flats remain leasehold.

The company owns the registered freehold.

Each flat owner may also own a share in that company.

Over time, the leaseholders may decide to extend their leases—perhaps to 990 or 999 years—and reduce the ground rent to a peppercorn.

Commercially, that can make perfect sense.

A longer lease may:

• make the flat easier to sell;
• make mortgage finance easier;
• remove concerns about a diminishing lease term;
• eliminate future ground rent liabilities; and
• potentially increase the value of the flat.

But that final point is exactly where the tax question begins.

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A “Free” Lease Extension Can Transfer Value

Suppose a flat is worth £400,000 with its existing lease.

After extending the lease and reducing the ground rent to a peppercorn, it is worth £450,000.

The obvious question is:

Where did that additional £50,000 of value come from?

Economically, at least some of that value may previously have been represented by the freeholder’s reversionary interest and its rights under the existing lease.

By granting the longer lease, value can move from the freehold interest into the leasehold interest.

If the freeholder is a company, that transfer of value may have tax consequences—even if the leaseholder hasn’t written the company a cheque.

For Capital Gains Tax purposes, HMRC generally treats an extension of a lease outside its original terms as involving a surrender of the existing lease and the grant of a new lease.

This is why describing the transaction as a “free lease extension” can be misleading from a tax perspective.

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Bicknell Towers – A Worked Example

Let’s take a fictional block called Bicknell Towers.

Bicknell Towers contains eight flats.

Each flat owner owns:

• the lease of their individual flat; and
• one share in Bicknell Towers Freehold Limited.

Bicknell Towers Freehold Limited is shown at HM Land Registry as owning the freehold.

The existing leases have around 75 years remaining and provide for ground rent.

The residents decide that they would like to:

extend every lease to 999 years and reduce the ground rent to a peppercorn.

Nobody intends to charge anybody anything.

It sounds straightforward.

But before the solicitor prepares the lease extensions, there are two crucial questions we need to answer.

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Question 1 – Who Really Owns the Freehold?

This is arguably the most important question in the whole transaction.

Are Free Lease Extensions Taxable? – Steve J Bicknell Tel 01202 025252

The fact that Bicknell Towers Freehold Limited is shown at HM Land Registry as the registered proprietor does not necessarily answer the question of beneficial ownership.

We may need to examine:

• the company’s Articles of Association;
• the circumstances in which the freehold was originally acquired;
• shareholders’ agreements;
• declarations of trust;
• historic correspondence;
• company resolutions; and
• the company’s accounts.

Why?

Because there can be a fundamental difference between the company holding the freehold:

as nominee or trustee for the flat owners

and

beneficially in its own right.

If the company is merely holding the freehold as nominee for the leaseholders, the tax analysis may be very different.

If, however, the company owns the freehold beneficially, granting valuable 999-year leases to its shareholders for nothing could potentially represent a disposal of part of the company’s valuable freehold interest.

Bicknell Business Advisers’ Advice

Don’t assume that owning one share in the freehold company means you beneficially own one-eighth of the freehold.

Company ownership and beneficial ownership are not necessarily the same thing.

Establish the legal position before doing the tax calculation.

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Question 2 – What Is the Lease Extension Actually Worth?

Once ownership has been established, the next step is normally to obtain a professional valuation.

It isn’t sufficient to say:

“We’re all shareholders, so we’ll just extend the leases for £1.”

For tax purposes, the transaction may need to be considered by reference to market value, particularly where connected parties are involved.

A suitably qualified valuer may therefore need to consider:

• the value of the flat before the extension;
• its value after the extension;
• the remaining term of the existing lease;
• the existing ground rent;
• the value of the freeholder’s reversion;
• the effect of extending the lease; and
• the value attributable to reducing the ground rent to a peppercorn.

This isn’t simply a compliance exercise.

The valuation may drive the tax calculation.

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How Could the Freehold Company’s Tax Be Calculated?

Let’s return to Bicknell Towers.

Assume, purely for illustration:

Value of flat before lease extension: £400,000

Value after lease extension: £450,000

Value potentially transferred: £50,000

The actual valuation of a lease extension is more sophisticated than simply subtracting one flat value from another, so professional valuation advice is essential.

However, these figures demonstrate the principle.

For tax purposes, the grant of a long lease out of a freehold can constitute a part disposal of the freehold interest.

That brings us to an important Capital Gains Tax calculation.

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The A ÷ (A + B) Formula

Where there is a part disposal of an asset, the original acquisition cost normally needs to be apportioned.

The familiar formula is:

A ÷ (A + B)

Broadly:

A = market value of the part disposed of

B = market value of the part retained.

The resulting proportion determines how much of the freeholder’s original allowable cost can be attributed to the disposal.

That attributable cost is then taken into account when calculating the gain.

This can become particularly important where a company acquired a freehold many years ago for relatively little money.

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Bicknell Towers – A Simplified Corporation Tax Example

Suppose James owns Flat 1 at Bicknell Towers and is also a shareholder in Bicknell Towers Freehold Limited.

The company grants James a 999-year lease extension and reduces his ground rent to a peppercorn.

James pays the company nothing.

For illustration, assume:

Calculation	Amount
Market value attributed to lease extension	£50,000
Less attributable allowable cost	(£5,000)
Illustrative gain	£45,000

If that £45,000 gain were chargeable at a 25% Corporation Tax rate, the illustrative tax would be:

£45,000 × 25% = £11,250

The actual tax calculation would, of course, depend on the valuation, the company’s original acquisition cost, the precise legal structure, available reliefs and the company’s Corporation Tax position.

But it demonstrates the potential problem.

James paid £0.

The residents called it a free lease extension.

Yet Bicknell Towers Freehold Limited could potentially have a taxable transaction based on market value rather than cash received.

That is why valuation and ownership need to be established before proceeding.

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Could James Also Have a Tax Issue?

Potentially.

From the leaseholder’s perspective, extending a lease outside its existing terms can involve the surrender of the old lease and acquisition of the replacement lease.

That means there may potentially be a disposal for Capital Gains Tax purposes.

If Bicknell Towers is James’s main residence and the necessary conditions are satisfied, Private Residence Relief may protect some or all of the gain.

But what if Flat 1 is:

• a buy-to-let;
• a second home;
• owned by a company; or
• a property that hasn’t always been James’s main residence?

The position needs closer examination.

This is another reason why every leaseholder’s circumstances shouldn’t automatically be assumed to be identical.

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What About ESC D39?

There is an important HMRC concession known as Extra-Statutory Concession D39. CG71240 – Leases: disposal: extension of lease: ESC D39 – HMRC internal manual – GOV.UK

Broadly, subject to its conditions, HMRC may allow the surrender of an existing lease and grant of a replacement lease to be treated as involving no disposal of the old lease and no separate acquisition of the replacement lease.

However, the conditions matter.

One important consideration is whether the transaction takes place on terms equivalent to those that would have been agreed between unconnected parties bargaining at arm’s length.

That creates an obvious question at Bicknell Towers.

If Bicknell Towers Freehold Limited grants James a lease extension worth £50,000 and James pays:

£0

would independent parties have agreed the same transaction?

This needs careful consideration rather than assuming ESC D39 automatically applies to every lease extension.

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Could There Also Be a Distribution Problem?

This is perhaps the tax trap that will surprise readers most.

Suppose Bicknell Towers Freehold Limited beneficially owns the freehold.

The company then grants James, one of its shareholders, a valuable lease extension for nothing.

Economically, the company may have transferred value to its shareholder.

That raises a separate question:

Could the benefit provided to James amount to a distribution for tax purposes?

Potentially, yes.

The company/shareholder tax consequences therefore need to be considered alongside the company’s chargeable gain.

In the wrong circumstances, it isn’t necessarily just the company’s Corporation Tax position that needs attention.

There could potentially also be a personal tax consequence for the shareholder receiving the benefit.

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What If James Pays Market Value?

You might think there is an easy answer.

Instead of giving James a £50,000 lease extension for nothing, Bicknell Towers Freehold Limited charges him £50,000.

That may help address some of the market-value and arm’s-length issues.

But it creates another practical problem.

Bicknell Towers Freehold Limited now has:

£50,000 cash

What happens to it?

If the money remains within the company, that may be fine.

But if the intention is ultimately to return it to James or distribute accumulated funds amongst the shareholders, extracting that cash may itself have tax consequences.

So simply saying:

“We’ll charge market value.”

doesn’t necessarily solve the overall problem.

You need to consider the entire transaction, not one tax in isolation.

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What About SDLT?

Stamp Duty Land Tax (SDLT) should also be checked.

Extending the term of a lease can, for legal and SDLT purposes, amount to the surrender of an existing lease and the grant of a replacement lease.

There are specific SDLT rules concerning surrender and regrant transactions, consideration and overlapping leases.

In many share-of-freehold lease extension arrangements there may ultimately be little or no SDLT to pay, particularly where there is no chargeable consideration.

However, I would not assume that every lease extension is automatically outside SDLT.

Check the specific transaction.

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Seven Things to Check Before Extending a Lease

Before Bicknell Towers signs anything, I would want answers to these seven questions:

1. Who legally owns the freehold?

Check the Land Registry title.

2. Who beneficially owns the freehold?

Don’t assume the registered proprietor tells the whole story.

3. Is the company a nominee or the beneficial owner?

This could fundamentally change the tax analysis.

4. What is the existing lease worth?

Obtain professional valuation advice.

5. What will the extended lease be worth?

You need to understand how much value is being transferred.

6. What would independent parties pay for the extension?

A nominal £1 consideration doesn’t necessarily mean the taxable value is £1.

7. What taxes need to be considered?

Potentially:

• Corporation Tax;
• Capital Gains Tax;
• taxation of distributions; and
• SDLT.

Only once those questions have been answered would I recommend proceeding with the legal documentation.

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The Biggest Mistake – Extend First, Ask the Accountant Later

This is probably the most important point in the whole article.

Leaseholders naturally start by speaking to their solicitor.

That’s understandable—the solicitor prepares the lease extension.

But the solicitor preparing the lease may not be responsible for calculating:

• the freehold company’s Corporation Tax;
• the shareholder’s personal tax position;
• the market value transferred; or
• the wider tax implications of the structure.

Once the 999-year leases have been granted for nothing, the transaction has happened.

It can be considerably more difficult to address an unexpected tax liability afterwards.

Bicknell Business Advisers’ Advice

The correct order should normally be:

1. OWNERSHIP → 2. VALUATION → 3. TAX → 4. STRUCTURE → 5. LEGAL DOCUMENTATION

Don’t sign first and calculate the tax later.

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What Does “Share of Freehold” Actually Mean?

This phrase causes enormous confusion.

Estate agents routinely advertise flats as:

“Share of Freehold”

But that description tells you surprisingly little about the underlying legal and tax structure.

You might own:

• a share in a company that beneficially owns the freehold;
• a direct beneficial interest in the freehold;
• an interest under a trust;
• a company share carrying particular contractual rights; or
• some other legal arrangement.

Those aren’t necessarily the same thing for tax purposes.

So before granting a valuable lease extension for nothing, establish precisely what everyone actually owns.

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A “Free” Lease Extension Isn’t Necessarily Tax Free

That is really the takeaway from Bicknell Towers.

The residents may look at the arrangement and think:

“We already own the freehold, so we’re simply extending our own leases.”

But if Bicknell Towers Freehold Limited actually owns the freehold beneficially, the tax analysis could look very different.

The company may potentially be disposing of a valuable interest in land to its shareholders.

That is why two apparently identical blocks of flats can potentially have completely different tax outcomes.

It depends on what the legal documents actually say.

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Don’t Forget the Valuation

If there is one practical lesson beyond establishing ownership, it is this:

Get the property professionally valued.

Tax advisers cannot reliably calculate a market-value tax charge by guessing the value of a lease extension.

A suitably qualified surveyor or leasehold valuation specialist may need to determine the value of:

• the existing lease;
• the extended lease;
• the freeholder’s interest before the transaction;
• the retained freehold interest afterwards; and
• the value being transferred.

Those numbers then allow the tax adviser to calculate the potential consequences properly.

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How We Can Help

At Bicknell Business Advisers, we advise landlords, property investors, freehold companies and property businesses on the tax consequences of property transactions.

Before extending leases, we can work alongside your solicitor and professional valuer to establish:

• how the freehold is owned;
• whether the company owns it beneficially or as nominee;
• what valuations are required;
• whether the company could realise a taxable gain;
• whether shareholders could receive a taxable distribution;
• the Capital Gains Tax position of individual leaseholders; and
• whether SDLT needs to be considered.

If you own a flat with a share of the freehold and your residents’ company is considering extending the leases, take tax advice before the new leases are signed.

A transaction that appears to be free can sometimes have a surprisingly expensive tax consequence.

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About the Author

Steve Bicknell FCMA, CGMA is Managing Director of Bicknell Business Advisers Limited, specialising in property taxation, SDLT, Capital Gains Tax and tax planning for landlords, developers and property investors throughout the UK.