The interpretation of private residence relief

The case of HMRC v Gerald and Sarah Lee (2023) UKUT 242 focuses on the interpretation and application of private residence relief (PRR), also commonly referred to as principal private residence (PPR) relief, in the context of a residence built on the site of a previously demolished building.

PRR is a relief from Capital Gains Tax (CGT) which exempts all or part of a gain made from selling your only or main residence.

Chris Ryan, from PKF Francis Clark looks at the case, the facts and the outcome below.

In October 2010, Gerald and Sarah Lee (the Lees) purchased a piece of UK land for just under £2m. The purchased land had an existing residential unit which they intended to completely redevelop.

Between October 2010 and March 2013, the original residential unit on the land was demolished and the site was redeveloped, making way for a new dwelling. By March 2013, the construction of the new house was complete, and it became the Lees primary residence.

In May 2014 the Lees sold the property and claimed PRR on the entire gain made from the sale. HM Revenue and Customs (HMRC) disallowed the claim, arguing that the relief should only apply to the gain proportionate to the period during which the property was used as their primary residence.

Key legal points

The key issue was the interpretation of Section 222 and 223 of the Taxation of Chargeable Gains Act 1992 (TCGA 1992) and the ‘period of ownership’. The key question was whether the relief could be claimed on the entire gain made from the sale of the rebuilt residence.

The Lees argued that the rebuilt property, despite being on the same site, constituted a new dwelling house which fulfilled the conditions for PRR. They contended that a dwelling-house should be construed as a distinct entity and distinguished from the physical location.

In contrast, HMRC argued that when considering PRR, the focus should be on the site itself rather than on the physical structure. HMRC claimed that the term ‘dwelling-house’ in the legislation should refer to both the physical property and its location, and therefore, relief should only be granted for the period during which the property was used as a main residence, regardless of any demolition or rebuilding activity.

In January 2017, HMRC initiated an enquiry into the Lees’ 2014/15 tax returns. After a protracted period of discussions involving both parties, HMRC issued closure notices saying that some of the £540,000 capital gain made from the sale was subject to CGT. The Lees disagreed and they subsequently made an application to the first Tier Tribunal (FTT).

Court’s decision

The FTT acknowledged that one asset was purchased and sold, however, they disagreed with HMRC that a ‘dwelling house’ should include land.

The FTT emphasised that using ‘dwelling house’ in the legislation allowed the possibility of treating it as separate from the land within the same title and ruled in favour of the taxpayers, stating that the ‘period of ownership’ referred to the period of ownership of the dwelling house being sold and not the land.

Fundamentally, the FTT stated that whilst there is not a precise definition of ‘period of ownership’ in the legislation for PRR purposes, it was arguable that the natural reading of the legislation suggested that it referred to the period of ownership of the dwelling house sold. HMRC appealed the FTT decision, and the case then went before the Upper Tribunal (UT).

The UT upheld the FTT’s ruling in favour of the Lees, stating that the FTT had provided a clear and definitive interpretation of the relevant statutory terms. The UT concluded that the ‘period of ownership’ in the legislation referred to the ownership of the dwelling house, not the land. This interpretation was based on the language and structure of the statute itself.

The UT acknowledged that the legislation does not define ‘dwelling house’, but they emphasised that it should be understood in its ordinary sense. The UT judges also remarked on HMRC’s arguments and found that they had failed to provide convincing evidence to support their claim that PRR should extend to the land.

The UT pointed out that if the asset to which the period of ownership related was the land, specific and clear referencing in the legislation was absent and that ‘land’ is only referenced in the context of occupation and enjoyment of the dwelling house. They concluded that the legislation repeatedly mentioned specific assets when referring to periods of ownership, a key point missing in HMRC’s argument.

The tribunal noted that taxpayers have the right to demolish and rebuild their residences as they see fit, without infringing upon their entitlement to PRR. The court also emphasised that PRR is meant to provide a relief from CGT and should be interpreted broadly to achieve its purpose.

It is important to note that in 1993, a similar case (Henke) went before a Special Commissioner and it was held that Mr and Mrs Henke did not own the house until 1993 even though they had owned the land since 1982 and then subsequently constructed the new property. The Commissioner ruled that an apportionment was necessary under s 223(2), TCGA 1992 to limit the PRR due because they did not meet the ‘throughout the period of ownership’ condition in s.223 (1). The FTT in the Lee case, briefly described the reasoning but simply noted the (Henke) decision was not binding on it; the UT agreed with their view.

The UT is a superior court of record, which means that its decisions create legally binding precedent.

Implications of the decision

This case clarifies the interpretation of PRR in situations where a new residence is built on the site of a previously demolished property. The decision allows taxpayers to claim relief on the entire gain made from the sale of the rebuilt residence, rather than only the proportionate amount based on the period of primary residence.

The ruling also confirms the application of S.223ZA which provides relief where the individuals residency is delayed by certain qualifying events, which includes a 24-month grace period for the completion of the construction of the dwelling. The period of construction up to the 24-month allowance is counted as ‘deemed occupation’ and is therefore fully relieved by PRR.

The ruling has potentially significant consequences for individuals and families interested in completely demolishing and rebuilding their primary residence. It provides greater flexibility and freedom for homeowners to make changes to their properties without losing the benefits of PRR.

Whilst this ruling will serve as a vital reference point for taxpayers navigating the complexities of UK CGT, the Henke case decision has historically been prominent in determining how in practice, advisers can assist their clients when confronted with complications around applying PRR.

PKF Francis Clark has helped clients in the past who have been in a similar position and we have provided advice which has not contradicted the ruling in the Lee case. This re-affirms the need for seeking advice from experienced tax advisers.