Repairs and Reliefs

DAVID HOLE considers the problem of deferred revenue expenditure incurred by traders and property investors.

EVEN IN THE information age, businesses need premises. The cost of maintaining and refurbishing business premises can be considerable, but the potential tax relief is equally significant. To get the best result for the client, it is necessary to claim the benefit of the doubt in borderline cases. The purpose of this article is to show how some recent changes have shifted the benefit of the doubt.

Statutory references are to the Capital Allowances Act 2001, unless otherwise specified.

Traditional orthodoxy

In my apprenticeship days, I was taught to analyse repair and maintenance expenditure on premises, whether taken to the profit and loss account or the balance sheet, under three headings. In descending order of attractiveness, these were:

• deductible as revenue;


• qualifying for plant and machinery allowances;


• potential base cost for chargeable gains purposes.

Non-qualifying capital expenditure was (and remains) the least beneficial possibility. It is disallowable and will only be deductible in computing the chargeable gain on disposal of the asset, if it is reflected in the state or nature of the asset at that time. Conversely, revenue expenditure was deductible when incurred.

There have been two important changes in recent years. First, timing for the deduction of revenue expenditure is governed by section 42, Finance Act 1998. Section 42 requires profits to be computed in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law. It is therefore necessary to consider the accounting treatment. Secondly, under certain circumstances, first-year allowances are available for expenditure on plant and machinery in premises. For both these reasons, revenue expenditure will not necessarily be relieved more quickly than expenditure on plant.

Traders

Take the case of an individual or corporate trader (not a property developer or property dealer) who incurs repair and maintenance expenditure on premises and expects to make taxable profits for the foreseeable future. We shall assume that there is no need to consider the fixtures legislation in Part 2 of Chapter 14 to the Capital Allowances Act 2001 because the taxpayer owns the freehold of the premises, that flat conversion allowances under Part 4A of the Act are not in point, and that the premises do not qualify for agricultural buildings allowances or industrial buildings allowances. Since the premises do not qualify for industrial buildings allowances, the expenditure is excluded from long-life asset treatment.

Revenue deduction

The premises are tangible fixed assets. Financial Reporting Standard 15 applies to all tangible fixed assets except for investment properties within Statement of Standard Accounting Practice 19, and specifically addresses repair and maintenance expenditure on tangible fixed assets:

'Subsequent expenditure to ensure that the tangible fixed asset maintains its previously assessed standard of performance should be recognised in the profit and loss account as it is incurred.' (Financial Reporting Standard 15(34).)

The standard cites repainting a building structure as an example of such expenditure. Such expenditure is, as before, deductible when incurred.

However, Financial Reporting Standard 15(36) states that:

'subsequent expenditure should be capitalised in three circumstances:

'( a ) where the subsequent expenditure provides an enhancement of the economic benefits of the tangible fixed asset in excess of the previously assessed standard of performance;

'( b ) where a component of the tangible fixed asset that has been treated separately for depreciation purposes and depreciated over its individual useful economic life is replaced or restored;

'( c ) where the subsequent expenditure relates to a major inspection or overhaul of a tangible fixed asset that restores the economic benefits of the asset that have been consumed by the entity and have already been reflected in depreciation.'

Following section 42, Finance Act 1998, relief for revenue expenditure falling into one of those three categories will be postponed until it is released to profit and loss account, either by depreciation or (exceptionally) by recognition of an impairment loss under Financial Reporting Standard 11. The Revenue takes this point: see the June 2001 Tax Bulletin article on deferred revenue expenditure.

Financial Reporting Standard 15(83) states, 'Where the tangible fixed asset comprises two or more major components with substantially different useful economic lives, each component should be accounted for separately for depreciation purposes and depreciated over its individual useful economic life'. Therefore, it will often be appropriate to depreciate repair and maintenance expenditure more swiftly than the initial cost of the building.

Plant and machinery

If relief for revenue expenditure is going to be drip-fed in by depreciation, first year allowances will be more attractive. However, if the expenditure is to qualify for plant and machinery allowances, it must not only fall on the capital side of the capital/revenue boundary (see Malcolm Gunn's detailed article 'Keeping The Roof On' in Taxation, 17 August 2000 pages 513 to 517), but also qualify as expenditure on plant or machinery.

Sections 21 and 22, Capital Allowances Act 2001 disallow expenditure on buildings, structures, assets and works (as defined), and need to be read carefully. For example, List A in section 21 lists assets which are treated as buildings, including windows. Capital expenditure on windows will therefore be disallowable. The Revenue has, however, recently changed its mind about one borderline issue: it now accepts that the cost of replacing single-glazed windows by double-glazed equivalents is deductible as revenue (see Tax Bulletin No 59, June 2002).

However, sections 21 and 22 need to be read in conjunction with section 23, which lists expenditure unaffected by those sections. Expenditure within section 23 may qualify for plant and machinery allowances if it meets the usual tests (notably those set out in section 11). Again, section 23 must be read carefully. For example, expenditure on a new central heating system should fall within item 2 of list C in section 23 (and indeed the Revenue accepts that central heating systems are plant: Capital Allowances Manual at paragraph CA21200).

First-year allowances

If the expenditure is on energy-saving plant or machinery within section 45A, 100 per cent first year allowances will be available. See 'Efficient Allowances' by Rebecca Cave in Taxation , 17 October 2002 at pages 60 to 62.

Failing that, a 40 per cent first year allowance will be given if the taxpayer incurring the expenditure is a small or medium-sized enterprise within section 47 or 48.

Writing-down allowances

Other things being equal, if writing down allowances are given at 25 per cent on the reducing balance of expenditure, almost half the expenditure will be written off for tax in the first two chargeable periods (25 per cent + (25 per cent x 75 per cent) = 43.75 per cent). Therefore, writing down allowances will usually give a faster write-off than commercial depreciation.

However, in a borderline case where the sums at stake are substantial, it may be worth noting that writing down allowances at 25 per cent will leave a 'tail' of over five per cent of the expenditure still unrelieved after ten years. A short-life asset election is unlikely to accelerate relief for plant in premises, whereas capitalised maintenance expenditure can be written down to a recoverable value of nil (if, for example, the maintenance work needs to be repeated).

Suggested priority

Applying the general principles that the taxpayer wants the permanent benefit of obtaining tax relief and the cashflow benefit of obtaining tax relief sooner rather than later, we have the following hierarchy for analysing our trader's repair and maintenance expenditure:

• capital expenditure on energy-saving plant or machinery 100 per cent first year allowances;


• revenue expenditure written off when incurred 100 per cent deduction;


• capital expenditure incurred on plant or machinery by a small or medium-sized enterprise 40 per cent first year allowances;


• other capital expenditure on plant or machinery 25 per cent writing down allowances;


• revenue expenditure capitalised under Financial Reporting Standard 15(36) - deductible as and when released to the profit and loss account;


• non-qualifying capital expenditure enhancing base cost deductible on disposal, if reflected in the state or nature of the asset at that time.

Property investors

Most of the same rules apply if, in the example above, the taxpayer is a property investor taxed under Schedule A. However, there are some important differences.

Capital allowances

Property investors are caught by general exclusion 6 in section 46(2), Capital Allowances Act 2001, which applies if the expenditure is on the provision of plant or machinery for leasing. Such investors are therefore not entitled to first year allowances for expenditure incurred by small or medium-sized enterprises, and are only entitled to first year allowances for expenditure on energy-saving plant or machinery if the expenditure is incurred on or after 17 April 2002. See section 62, Finance Act 2002, and the Revenue's Capital Allowances Manual at paragraph CA23110.

Given the current popularity of 'buy-to-let', it may be worth recalling that property investors are not entitled to plant and machinery allowances for expenditure on plant or machinery for use in a dwelling-house (see section 35).

Revenue deduction

Section 42, Finance Act 1998 applies to Schedule A by virtue of section 21A(1), Taxes Act 1988. The profits of a Schedule A business are therefore to be computed in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law. It will therefore be necessary to consider the accounting treatment.

If the expenditure is written off to profit and loss account in the period in which it is incurred, then it will be deductible in that period. If, however, the expenditure is taken to the balance sheet, this creates difficulties. The property will almost certainly come within the definition of an investment property in Statement of Standard Accounting Practice 19(7): 'an interest in land and/or buildings ( a ) in respect of which construction work and development work have been completed, and ( b ) which is held for its investment potential, any rental income being negotiated at arm's length'. Under Statement of Standard Accounting Practice 19, investment properties are not depreciated. Instead, they are included in the balance sheet at their open market value. If, following Statement of Standard Accounting Practice 19, the repair and maintenance expenditure does not hit the profit and loss account, when is it deductible?

One answer would be that the standard does not permanently disallow the expenditure, and that relief is given eventually when the expenditure is released to the profit and loss account on disposal of the property. Although the Tax Bulletin No 59 article does not specifically mention Statement of Standard Accounting Practice 19, I understand that this is the Revenue's current approach.

However, this approach may well have anomalous results. Suppose that the property investor regularly incurs expenditure to enhance the value of the property, and that some of this expenditure is revenue in nature. If the property maintains its open market value, the expenditure will remain in the balance sheet, even though the property investor has had to incur further expenditure, because the benefit of the capitalised revenue expenditure has been used up. Relief for this expenditure will be deferred indefinitely. Moreover, if the expenditure finally becomes deductible when the property is disposed of, it may give rise to a Schedule A loss. Such a loss cannot be carried back, and an income tax Schedule A loss cannot be set against the chargeable gain on disposal of the property. Relief may therefore be denied altogether.

This is an absurd result. Section 42, Finance Act 1998 was introduced to give a level playing field for traders and professionals. The same Finance Act also introduced section 21A, Taxes Act 1988, doubtless to give a level playing field for traders and property investors. It cannot have been Parliament's intention to put property investors at a fiscal disadvantage compared with, for example, public house and hotel companies depreciating their properties under Financial Reporting Standard 15.

Possible solution

I think this problem can be solved. It is necessary to ask why Statement of Standard Accounting Practice 19 prohibits depreciation of investment properties. In 1980, the Accounting Standards Committee, publishing its exposure draft of that statement, set out its rationale: 'depreciation is only one element which enters into the annual change in the value of a property and as the use of a current value places the prime emphasis on the values of the assets, it is not generally useful to attempt to distinguish, estimate and account separately for the element of depreciation, and depreciation, although not separately identified, will be taken into account in dealing with changes in current values' (my emphasis). Therefore, in a Statement of Standard Accounting Practice 19 revaluation, there is a depreciation charge, which is effectively netted off against a valuation credit, although it is not generally accepted accounting practice to show the charge and the credit separately.

For tax purposes, is it possible to go behind the Statement of Standard Accounting Practice 19 figures? Yes, there is an escape hatch in section 42, Finance Act 1998 which states that profits are to be computed in accordance with generally accepted accounting practice 'subject to any adjustment required or authorised by law'. That escape hatch can be used in the scenario under review. There is a carefully-worded obiter dictum from Sir Thomas Bingham, Master of the Rolls in Gallagher v Jones [1993] STC 537:

'I find it hard to understand how any judge-made rule could override the application of a generally accepted rule of commercial accountancy which ( a ) applied to the situation in question, ( b ) was not one of two or more rules applicable to the situation in question, and ( c ) was not shown to be inconsistent with the true facts or otherwise inapt to determine the true profits or losses of the business.'

The scenario under discussion comes within clause ( c ) of the Bingham dictum . Statement of Standard Accounting Practice 19 is 'inapt' to determine the true profits or losses of the business for tax purposes; therefore an adjustment will be required or authorised by law. However, if Statement of Standard Accounting Practice 19 is not followed, when should relief be allowed, given that Parliament, the courts and the Revenue have set their faces against the cash basis?

I suggest that revenue expenditure held in the balance sheet under Statement of Standard Accounting Practice 19 should be deductible in the periods in which it would have been released to the profit and loss account as depreciation, if Financial Reporting Standard 15 had applied. In other words, depreciation of deferred revenue expenditure, though not separately identified in accounts following Statement of Standard Accounting Practice 19, needs to be analysed out for tax purposes.

This method should be acceptable, as it should give sensible and fair results. First, the Accounting Standards Board states in its summary of Financial Reporting Standard 15 that 'the fundamental objective of depreciation is to reflect in operating profit the cost of use of the tangible fixed assets ( i.e., the amount of economic benefits consumed by the entity) in the period'. Therefore, allowing tax relief for the 'cost of use' of the revenue expenditure should, in principle, give sensible results, i.e. , to the extent that the benefit of the expenditure has been used up, it is deductible, and to the extent that it has not, relief is postponed. Secondly, this method is neutral between taxpayer and Crown, as well as between taxpayers applying Financial Reporting Standard 15 and taxpayers applying Statement of Standard Accounting Practice 19. So it is fair.

Revenue reluctance

Clients should, however, be warned that the Revenue will not be quick to allow relief for a loss which has not appeared in the accounts. In this context, it is worth noting that a similar difficulty can sometimes arise with finance lease rentals. If the rental expenditure is retained in the lessee's balance sheet indefinitely, when will relief be given? The Revenue has published its practice on this point. If, but only if, there are accounting rules which prevent finance lessees from depreciating their assets, relief is allowed on the basis of the depreciation which would have been charged in the absence of this requirement (see the Inspector's Manual at paragraph IM2677b). So, it may be that the Revenue would be willing to accept a similar solution to the similar problem arising with Statement of Standard Accounting Practice 19. Certainly, the analogy appears strong enough to justify filing the return on this basis (with full disclosure).

Alternatively, it may be possible for a corporate property investor to cut the Gordian knot. If the property is transferred intra-group, this will trigger a disposal and crystallise the revenue deduction.

Practical considerations for all

It is axiomatic that a tax relief is not valuable unless and until it reduces a tax liability. However, when seeking to analyse a large amount of heterogeneous expenditure in the light of a wide variety of statute, case law and accounting practice, one may lose sight of that axiom. In the limiting case, if the client has mountainous losses sufficient to cover taxable profits for the foreseeable future, it may well make very little difference whether expenditure is categorised as revenue or plant. In such a case, a broad-brush analysis is likely to be acceptable to both the client and the Revenue. More generally, one needs to bear in mind the marginal rate or rates at which relief will be given and the dates at which it will be given.

There is important material in the relevant Revenue manuals, notably the Inspector's Manual at paragraphs IM990 et seq on repairs and replacements, and the Capital Allowances Manual at paragraphs 21010 et seq on plant in buildings. Consulting these manuals may save a lot of research time and may even save the client tax. For example, can plant and machinery allowances be claimed on door handles? The answer is yes, if they have moving parts see the Capital Allowances Manual at paragraph 21200.

David Hole BA, ACA is a freelance writer.

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