Commercial building refurbishments, renovations and conversions consistently cover some of the most complex tax areas, and early consideration across tax, finance and property teams can be critical to help avoid some of the pitfalls and make the most of the considerable tax opportunities on works to existing buildings. Here I discuss some of the most common areas I come across in practice.
Whose paying for the construction works?
Whether it’s a payment in lieu of dilapidations, a grant or even a tenant/landlord contribution, works to existing commercial buildings frequently throw up third party payments which can affect both the approach in any analysis as well as the tax outcome – early advice and planning is often critical.
For example, a dilapidation payment can be capital or revenue depending on circumstances and even a mix of treatment. A grant will usually require netting off the total cost but not always depending on the details/structuring of the award. Contributions between landlords and tenants can require identifying the different types of payments being made (which can have different tax treatments) and even need consideration of a range of issues including VAT, CIS, and capital allowances to avoid unsuspecting disputes, tax liabilities and even penalties.
Whatever the circumstances best practise dictates that the parties should agree how the expenditure will be categorised and budgeted at the outset and understanding the motivation and details behind these discussions along with accounting treatment will be critical in any future analysis.
If a compensation payment has been received from an insurance company, there will be further considerations. After expensing repairs and crediting any insurance proceeds as a receipt (e.g. for storm damage) it will normally only be the excess cost that remains allowable for a tax deduction. However, where the insurance claim relates to ‘capital’ works (e.g. building replacement) a different approach is taken.
The original buildings damage or destruction will likely be treated as part disposal for capital gains tax (CGT) purposes and the insurance proceeds as a capital sum received. Where such compensation is received, and is applied in restoring or replacing the damaged asset, the taxpayer may be entitled to relieve some, or all of the charge to CGT.
If the business has claimed either plant and machinery allowances or research and development allowances (not structures and buildings allowances) they will be required to treat the loss or destruction of the asset as a disposal and the insurance proceeds will need factored in to any disposal value. When the asset is replaced the insurance proceeds can be ignored for the new qualifying expenditure incurred – netting off is not appropriate.
Also, extra care should be taken whenever there is a payment between 'connected persons' as not only can the expenditure be excluded from the £1 million Annual Investment Allowance and 100%/50% First Year Allowances (Full Expensing) the contributor can also be denied from claiming Contribution Allowances.
Alongside ownership which can have special meaning for tax purposes (e.g. the long funding lease and fixtures rules contained in Part 2 – Chapter 6 and 14 of the Capital Allowances Act 2001) who is incurring the costs is a fundamental principle in determining who is entitled to tax relief. If a service is being provided (e.g. to carry out works that another party might normally carry out) additional ‘bear traps’ can arise and there is a helpful summary article in TaxAdviser with specific focus for landlord contributions.
Are the construction works capital or revenue?
Building refurbishments and alterations can often contain a mix of new elements alongside the repair or replacement of existing assets. For example, works to extend a building (a capital improvement) are frequently carried out at the same time as other works to the existing premises (e.g. car park re-surfacing).
If the building has just been acquired or the new works so substantial (e.g. change in character or use) then ‘capital’ treatment for tax purposes may seem obvious and if this matches accounting treatment then its probably correct. However, where the building has been in use by the owner before works began (occupied or leased) then there is a high chance a mix of works is being carried out.
If there is a dispute, tax law determines whether an item of expenditure is ‘capital’ or ‘revenue’ in nature not its accounting treatment. When a business prepares its accounts under general accepted accounting principles HMRC are unlikely to challenge a genuine deduction for repairs, but it can and does so, particularly when there is an element of improvement, alteration or change in use. HMRC carried out an extensive review of its repair guidance in 2013 following a number of tax tribunal decisions and the results can be found in BIM46900.
A further complication with accounting and normal tax treatment is the statutory override for ‘integral features’ which requires automatic capital allowances treatment where the affected assets (heating, lighting, air-conditioning etc.) are substantially replaced (>50% of cost). This is not always easy to administer in practice and when partial replacement works are carried out additional analysis is almost always needed.
Another twist is when expenditure is recognised for tax purposes. Items of revenue expenditure will generally follow their accounting treatment which means if they are ‘capitalised’ (e.g. as a freehold or leasehold improvement) the business will only get a tax deduction as it is amortised/depreciated which for property landlords and infrastructure owners can result in spreading tax relief over a very long time, if at all. If it is ‘capital’, the capital allowances legislation will determine when expenditure is incurred not WIP status or accruals.
The land remediation rules (CTA 2009 – Part 14) are a valuable relief that allows companies to claim an enhanced deduction of up to 150% of the qualifying expenditure involved (e.g. asbestos removal or barrier containment). For ‘revenue’ expenditure the matter of claiming an extra 50% deduction is straight forward whereas for ‘capital’ expenditure there is a capital allowances restriction which can rule out a claim in its entirety.
These differences can create practical challenges and opportunities which can only ever be fully optimised if they are considered early not just in the construction process but also in accounts and tax computation preparation.
Anyone that seeks to prepare an analysis for works to existing buildings without a full understanding of the facts together with a readiness to proactively work in co-operation with tax, finance, property and accounting teams is heading for disaster.
How to Optimise Tax Opportunities in Existing Buildings with Incidental Building Alterations?
Once you have established that your project contains genuine ‘capital’ works a further provision in the Capital Allowances Act (CAA) 2001 that sets works to existing buildings apart from other projects is CAA 2001 s25: -
"If a person carrying on a qualifying activity incurs capital expenditure on alterations to an existing building incidental to the installation of plant or machinery for the purposes of the qualifying activity, this Part applies as if—
(a) the expenditure were expenditure on the provision of the plant or machinery, and
(b) the works representing the expenditure formed part of the plant or machinery."
What this means in practice is that some building works which would not qualify in a new build scenario can - provided there is a direct link between the incurring of the expenditure and the installation of the qualifying plant or machinery.
For example, the construction of walls to create a new kitchen or toilet area is unlikely to qualify whereas the construction of a lift shaft in an existing building to support a new lift and its accompanying infrastructure most likely will (CA21190). Other examples include the removal of a staircase or wall to install an item of plant like an escalator or strengthening an existing floor to support a heavy item of equipment like an industrial fridge or cold store.
Similarly, the works must actually be to an existing building (i.e. not just a structure) which means incidental building works for new plant or machinery installed in extensions that increase the curtilage are unlikely to qualify (e.g. new roof top plant room or adjacent energy centre).
A frequent question in capital allowances and related reviews is when to get specialist input. The simple truth is that there is rarely anything to be lost in having a discussion early. Getting on site, inspecting the works and documenting ‘incidental alterations’ can not only improve the overall results it can also reduce risks and make compliance easier.
If you have a question or are considering starting works to an existing building please do not hesitate to get in touch.