Dilapidations payment is capital not revenue
A landlord successfully argued that compensation for dilapidations due under a lease should be classed as a capital receipt and not as revenue income.
The tenant: Albyn Housing Society Limited held a standard tenants’ repairing lease for a block of 18 flats, owned by James Thornton. Under the terms of the lease the tenant was responsible for maintenance of the flats, but they did not do so. This resulted in a “significant diminution” in the value of the flats, the first-tier tribunal heard (James Allan Thornton v HMRC TC05494).
The landlord and tenant reached a settlement of £250,000, which was included as creditor on the balance sheet of Thornton’s property accounts for the year ended 31 August 2010. The amount due was not included in the profit and loss account for business for that year.
“It was clear that the property had suffered a significant diminution in value due, in very large part, to the lack of upkeep on the part of the tenant,” the tribunal said. “It is equally clear that all of the settlement, and more, had been expended on the repairs. Shortly put, we have identified that the nature of the liability in this particular case was to make good the fall in capital value attributable to, and calculated by reference to, the dilapidations that the tenant had failed to make good.”
In their property income manual (PIM2020) HMRC provide two alternative tax treatments of an amount paid to a landlord under a dilapidations clause:
- capital receipt - where landlord disposes of the property
- revenue income – in other cases, as the income is likely to be compensation for the lower rent the property can deliver
The opinions given in the HMRC manuals are not law and the Tax Tribunal is not required to follow that guidance.
In this case, no doubt following the guidance in their property income manual, HMRC argued that the settlement should be treated as an income receipt in Thornton’s self-assessment tax return. HMRC state that this treatment was appropriate because the payment covered the loss of rental income due to the dilapidated state of the properties.
Thornton argued for the alternative tax treatment; that the settlement for dilapidations should be treated as a capital receipt, since it allowed him to safeguard his capital investment and it had been used to repair the property.
The tribunal found that, when the lease was terminated, due to the inaction of Albyn, Thornton had suffered a permanent diminution in the capital value of his investment and the settlement was to make good that loss.
The tribunal agreed with Thornton that the settlement should be classed as a capital receipt. When explaining her decision, the tribunal judge, Anne Scott, cited a tax case in 1950 (Lord Keith in CIR v West), which also centred on a payment to compensate for damage to a property.
The Lord Keith ruling said: “… I cannot agree that a sum paid for damage caused by abuse, or a non-stipulated use, of the thing hired is a trading receipt. It is money paid to enable the owner to restore his property, if possible, to the condition in which it may again become suitable for use or hire, or, if restoration is impossible, to compensate him for the loss or depreciation of a profit-earning subject”.
|AccountingWEB analysis from Rebecca Cave
The classification of a receipt as capital or revenue can make a huge difference to the amount of tax paid by the recipient. HMRC will always follow the guidance in its own manuals, but such an opinion should not be accepted without question as it does not have the force of law. It is always worth challenging a decision made by HMRC which is based purely on their internal manuals, and not on a solid base of case law.