Participating in the private rented sector – key legal considerations for councils wanting to participate

Nathan Holden, Freeths, Nottingham

Local authorities up and down the country are constantly on the lookout for ways to generate new income sources. A popular and topical option, especially in parts of the country where property prices are high, is to provide private rented sector housing. This can be for a number of reasons; some authorities are looking to improve investment return on the financial reserves they hold, because the private rented sector potentially offers much higher rates of return than normal bank interest, others seek a reliable revenue stream to help balance the books.

Whatever the motivation, there are a number of basic issues to consider:

  • regulatory controls – what are they and do they cause a problem?
  • does housing for rent need to be provided through a separate entity (ie from the local authority)?
  • powers – is there a power to do this?
  • state aid and EU procurement – where does this fit in?
  • tax issues.

Regulatory controls

Having decided to embark on providing private rented sector housing, one of the first issues that a local authority will encounter is that the powers given to local authorities for housing purposes do not contemplate that housing would be provided on a commercial basis by local authorities.

Local authorities, in general, may only grant secure tenancies. In addition, after a qualifying period, secure tenants are entitled to exercise the right to buy their rented home at a discount. This works if providing housing for rent is an end in itself but not if viewed as an investment opportunity, and from a funder’s perspective it is not attractive. For this reason, the housing must be provided through a separate entity so that more investment-friendly forms of tenancy, for example, assured short-hold tenancies, may be offered.

Local authorities must maintain, when exercising their housing function, a housing revenue account. This is more a special accounting treatment, rather than an account, that ring-fences the income and expenditure in respect of housing provided through the exercise of a local authority’s housing powers. The account causes a number of problems; it cuts across a local authority’s powers to borrow prudentially, in that it effectively imposes borrowing limits when the prudential borrowing does not, and land held or accounted for in the housing revenue account is subject to different disposal requirements than those that relate to land held for general purposes; this point is explored further below.

Structure and powers

For the reasons mentioned above, in practice, private rented sector housing provided by local authorities is delivered through a separate corporate entity to that of the local authority. As to the choice of the appropriate structure, this is linked to the availability of legal powers. The general power of competence in section 1 Localism Act 2011 is an obvious candidate, although section 4 restricts the use of the power for commercial purposes to circumstances where a local authority participates in the commercial activity through a limited company. However, there may be other alternatives if trading for a profit is not the objective, for example, a company limited by guarantee. A disadvantage of operating through a company is the requirement to pay Corporation Tax. Local authorities do not themselves pay Corporation Tax, but dividends generated by the company are taxed at source, so operating through a company is less tax efficient. There are certain types of legal structure that would allow a local authority to benefit from its non-taxpaying status, for example a limited liability partnership. However, it is questionable whether participating in these structures is within a local authority’s powers because of the degree to which providing private rented sector housing may constitute trading.

Linked to the issue of the powers of participation are the issues around providing funding to the vehicle. Again, the power of general competence is the obvious option. There are other more specific powers; section 12 of the Local Government Act 2003 which permits a local authority to invest for any purpose relevant to its functions under any enactment, and section 24 of the Local Government Act 1988 gives the power to provide finance for private sector housing.

State aid

If a local authority provides finance, guarantees or any benefit to a party, this may constitute State aid if the recipient is an economic undertaking and the benefit is capable of distorting competition, thereby affecting trade between member states. To assist local authorities in determining the appropriate level of interest to charge on loans provided by a local authority to an economic undertaking, the EU Commission has published advice and periodically publishes reference interest rates, above which loans will not be deemed potentially to be State aid. The average rate applicable to the UK currently is 2.04 per cent. Where a local authority is able to borrow using its prudential borrowing powers, then these interest rates tend to be competitive and there is scope to charge a slightly higher rate in lending those funds to a private rented sector entity, thereby allowing the local authority to generate a return on the provision of the finance.

EU procurement

The Public Contracts Regulations 2015 apply to contracts awarded by contracting authorities including local authorities for works, services or supplies. To underpin the arrangements between the local authority and the private rented sector entity, this is likely to involve a contract for works or services or a combination of both. Further, the Concession Contracts Regulations that are due to come into force on 18 April 2016 may apply where a concession contract is awarded.

Clearly, if a local authority has established an entity for the purposes of promoting the development of housing for rent, its relationship with it will involve the local authority in procuring, at the very least, services from the entity. Normally, the approach is to place reliance on Regulation 12 of the 2015 Regulations. This allows a local authority to award a contract directly to a private rented sector entity that it wholly owns if, in return, the entity is devoted to providing an essential part of its activities (80 per cent or more) to the local authority.

Where will the land come from?

Having set up a private rented sector entity, how does the local authority, as this is usually the case, transfer land it holds to that entity? If the land is held within the housing revenue account it may only be disposed of in accordance with section 32/43 Housing Act 1985 this requires the Secretary of State’s consent, given either specifically or generally. There is a general consent permitting the disposal of vacant housing revenue account land at any price and there are also other consents that may assist. Further, section 25 of the Local Government Act 1988 provides that the Secretary of State’s consent is needed for any financial assistance given by a local authority for privately let housing. Clearly if the local authority is to provide funds by way of loans to the private rented sector entity these provisions will be relevant. If consent is obtained under section 25, no further consent under section 32/43 is required.

If the land is held for general landholding purposes, then the disposal power will be pursuant to section 123 Local Government Act 1972. This imposes a duty to secure the best consideration that can be reasonably obtained unless the land is disposed of by way of a very short lease (less than seven years) or the Secretary of State gives consent. Circular 06/03 provides a general consent that permits the disposal of land at an under-value of £2 million without specific consent, as long as the disposal will promote the wellbeing of the local authority’s area.

Tax position

The potential tax implications arise from Stamp Duty Land Tax (SDLT), Corporation Tax and Value Added Tax (VAT). They impact both the private rented sector entity and the local authority in different ways. The transfer of land to the private entity is unlikely to incur SDLT because the entity is likely to be over 75 per cent owned by the local authority. The private rented sector entity will be required to pay corporation tax on the generation of rental income profits as well as capital gains, if a company, and is likely to be subject to VAT. In contrast, the local authority can recover VAT through section 33 Value Added Taxes Act 1994, as long as the VAT supplies (that is, the service it receives) relate to non-business activities of the local authority. It is important to consider fully the tax implications when contemplating arrangements of this type.

Conclusions

As set out above, there are a variety of issues to consider before embarking on, or participating in, an arrangement of this type. It is important that the local authority’s advisors fully understand the issues and find ways to overcome the hurdles, a handful of which have been explored in this article.

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