Updated: Jul 5, 2020
Properties require regular maintenance and occasional transformational expenditure to adapt to changing market needs and trends. A common challenge faced by both Landlords and Tenants is how to fund such expenditure efficiently.
The tax issues in effectively structuring such payments can be complex and because the tax status of the parties may vary between deals, what works best in one scenario may not in another, so it is always best to look at transactions on a case by case basis with the general principles in mind.
Contributions towards tenant fit-outs
General cash payments (reverse premiums) can be taxable on the recipient and non-deductible for the payee. However, a Landlord that contributes towards a tenant fit-out may be entitled to capital allowances under the Contribution Allowances rules.
Expenditure that qualifies for capital allowances and reduces the Tenants claim will not be taxed as a reverse premium so it can also be in their interest to allocate accordingly.
If the contributor and the recipient are connected no capital allowances claim is available to the Landlord.
With the introduction of the new Structures and Building Allowances for contracts on or after 29 October 2018 this is likely to mean most of these payments will be capable of qualifying for relief.
With four different capital allowances rates of relief (100%, 18%, 6% and 2%) there are obvious advantages in structuring payments to suit optimal relief depending on the tax status, relationship and tax capacity of the parties involved.
In order to achieve the best commercial result, it is essential that this is negotiated and set out clearly in the lease/development agreement. Ignoring it does not solve the problem. In the absence of any detail a pro-rated apportionment of the total claim will be needed and HM Revenue & Custom (HMRC) is likely to seek evidence of parity in treatment.
Tenant’s completing Landlord Works as part of Tenant Fit Out
HMRC recognise that some lease inducements that could be construed as reverse premiums do not fall within the scope of those words and can be treated as tax-free.
For example, HMRC have stated that a payment made from landlord to tenant to complete the construction of an unfinished building is not taxable as a reverse premium, notwithstanding that the relevant expenditure may not all qualify for capital allowances (HMRC Business Income Manual, 41085).
If the building work enhances the value of the landlord’s reversion and would generally be considered when setting the market rent at a rent review, then it is probably part of the construction of the building, not part of the fit-out. If work on the building fails those tests, it is probably part of the fit-out and a payment to fund it would be in the reverse premium rules for the recipient and taxed accordingly unless it qualifies for capital allowances.
A common risk when additional work is carried out by the Tenant is a failure to properly consider the VAT implications arising from the Tenant taking on more of the Landlords obligations and having to account for VAT.
If the Tenant is not an anchor tenant, the VAT treatment of the payment will depend on whether the cost of its fit-out is a cost that a landlord would normally be expected to incur. If this is the case, the payment will be VATable. Otherwise, the payment will be outside the scope of VAT.
Landlord’s completing works on behalf of Tenants
Instead of Tenant’s paying for fitout works it is not uncommon for Landlords to meet the initial cost and adjust their rents accordingly. In such cases the Landlord will normally find the level of qualifying expenditure for capital allowances increase.
However, a Landlord that fits out a property beyond a standard fit-out (e.g. installation of trade equipment or furniture) and increases rents to fund the extra cost will also need to satisfy the “long funding lease” (LFL) rules because they may be leasing back non “background plant or machinery”.
Most property leases are excluded from this anti-avoidance provision because of the general “background plant or machinery” exclusion; however, assets that are not affixed to the property (e.g. loose equipment) cannot benefit. The LFL rules trigger a different capital allowances entitlement and tax relief calculation.
Whatever the project, the objective on both sides will be to do the best commercial deal possible and both the tax status of the parties and nature of the works can alter the planning options involved.
If you have any questions, or would like to discuss any aspect of this article, please do not hesitate to contact us.