Capital contributions – too taxing for tenants?

In today’s troubled economy the property market is in decline and landlords increasingly have to offer incentives to potential tenants to fill vacant units. These incentives may come in the form of capital contributions, particularly where incoming tenants carry out property fit outs to make them suitable for purpose. It is often the case that tenants are unsure how to structure contribution agreements to ensure that they are optimised for tax purposes, resulting in additional tax being paid unnecessarily.

Capital contributions fall under the reverse premium legislation contained in Finance Act 1999. The treatment of any contribution will depend on the intention of the payment and the terms of the lease agreement. It is important that the agreement is clearly worded to ensure both parties are clear as to what the contribution is towards and the associated tax implications.

Home improvements
Often to encourage a tenant into a property, the landlord may agree to incur expenditure to modify the existing property to meet the tenant’s requirements. These works may be carried out directly by the landlord, or the tenant may undertake these on the landlord’s behalf while the tenant has contractors on site carrying out fit out works. Landlord’s works effectively ‘complete a building’ on behalf of the landlord, and therefore are treated as a non-taxable reverse premium in the hands of the tenant. Where work qualifying for capital allowances is carried out as part of the landlord works, the benefit of the allowances will pass to the landlord. If the contribution agreement can be worded such that the contribution is firstly or solely towards landlords works and assets not qualifying for capital allowances then the tenant may benefit from both a tax free contribution and potentially additional capital allowances.

Alternatively, as encouragement to enter into a lease, a landlord may offer to contribute towards tenant fit out costs. Where the contribution is allocated to assets qualifying for capital allowances the landlord will gain the benefit of the allowances. Often overlooked is the fact that monies apportioned to non qualifying expenditure may be taxable as income for the tenant. Only if the fit out works carried out by the tenant are to be rentalised or are of value to the landlord upon termination of the lease, can a tax charge be avoided. Commercially speaking however, property agents acting on behalf of tenants will be seeking to ensure that the contribution is not rentalised as this will erase the benefit of the original capital contribution.

Contribution structures
So what is the optimum structuring of a contribution? One alternative is the commonly used rent free period. This gives significant potential benefit to the tenant, is not normally taxable and ensures the tenant retains the right to capital allowances on expenditure incurred. However, a landlord may prefer a capital contribution as this cost can be included as base cost to reduce capital gains tax liabilities in the future. If a capital contribution is used, and there are no landlord works to offset the contribution against, we should consider whether it is more beneficial to offset the contribution against costs qualifying for capital allowances (which will sacrifice the associated tax relief) or against costs non qualifying for capital allowances (which lead to the receipt being treated as taxable income).

Let us suppose that a tenant receives a contribution of £500,000 on a 30 year lease. We can contrast the tax implications for the tenant of the contribution agreement being structured towards first expenditure non qualifying for capital allowances, and secondly expenditure qualifying for general pool plant and machinery allowances.

In the first instance, if the contribution was towards expenditure not qualifying for capital allowances and thereby taxable as a receipt, the tax charge would be dependent on the accounting policy of the tenant. If the tenant accounts under IAS then under SIC15 the contribution receipt should be spread over the length of the lease, which results in a NPV tax charge to the tenant of £56,739 (28% tax rate, 8% discount rate). If the tenant accounts under UK GAAP then under UITF28 the contribution receipt should be spread over the shorter of the length of the lease or the period to the first rent review. If we take a typical rent review period of five years then there would be a NPV tax charge of £120,740, an additional charge of £64,001 when compared to a tenant accounting under IAS.

Alternatively, if the contribution agreement was worded such that monies were offset against tenants’ general pool plant and machinery then there would be no taxable income but a loss of potential tax relief to the tenant with a NPV of £107,940.

This example illustrates how structuring the contribution agreement to obtain the optimum tax position varies depending on the particulars of the example. Different types of capital allowances, the introduction of integral features and the annual investment allowance add further complexity to this area.

In reality there will always be a balance to be obtained between the requirements of tax and property departments. As is regrettably often the case, tax is often more of an afterthought than a decision making tool when faced with commercial reality. However, it is clear that significant savings can be made where property and tax departments work in harmony.

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Denise Montes is a senior consultant Bourne Business Consulting LLP, specialising in asset taxation and advising clients in the retail, real estate, pharmaceuticals and financial services sectors.