.png)
.png)
With the recent furore over the abolition of capital gains tax taper relief, Budget 2007 may feel a long time ago. But, for those working in infrastructure and transport, there remains one proposal in the Budget which has yet to be enacted and represents a far greater break from the past than the abolition of taper… the proposed abolition of industrial buildings allowance (IBA).
Enhancing competitiveness
Budget 2007 announced a 'business tax package' that was designed to 'enhance the competitiveness in the UK'. This contained the cut in corporation tax from 30% to 28%, which was predominantly offset in the corporate sector by the reduction in the rate of capital allowances from 25% to 20%.
As a package, this was a presentationally attractive one both for the Government and many companies, since it left the short-term cash payments of corporation tax at broadly the same level, yet reduced the headline tax rate and the tax charge in the accounts (since the change in capital allowances will merely represent a shift from deferred tax into current tax rather than a hit to the profit and loss account).
However, another element of the capital allowances changes was the abolition of IBAs. Unlike the change in the rate of capital allowances for plant and machinery, the IBA proposal set out in the Budget was the abolition of tax relief for depreciation on such assets, irrespective of whether those assets were purchased after, on or before Budget day.
While the Budget proposal is for the abolition of the relief, this will be achieved over a period of three years through denying relief in increasing levels, firstly by 25%, then 50%, 75% and finally 100% (resulting in relief rates of 3%, 2%, 1% and nil). This phased denial is described as a 'transitional regime'.
The then Chancellor, Gordon Brown, did not implement the changes in the Finance Bill 2007 so, failing a change in view, we can expect this to be included in Alistair Darling's first Finance Bill next year.
In the meantime, the consultation documents, including the one of 17 December, have provided more of the detail behind the Government's rationale for its decision.
The policy rationale
Like the changes to capital gains tax taper, there is, in principle, a strong rationale behind the Government's changes.
Distortion between commercial and industrial
The Government argues that the current system provides an incentive for investors to divert funds into industrial buildings rather than commercial buildings, due to the difference in tax treatment.
This builds on the consultation paper issued in 2003, in which the Government considered providing tax relief for depreciation on commercial buildings.
In doing so it noted that 'alignment of the tax system with economic concepts of income and profit would encourage business to invest in the most productive assets' and that there is an economic case for a tax system that 'reflects the rates at which assets depreciate in value'.
However, in Budget 2007 the Chancellor chose to 'level down' the relief for industrial buildings rather than to 'level up' the treatment for commercial buildings.
This is a regrettable change because it creates a 'tax nothing' rather than 'aligning with the economic concepts of income and profit'. There are two reasons put forward in support of this.
- Underlying value of the land — It has been argued that, when considering the asset as a whole (i.e. the building and the land that the building is situated on), there is an overall accretion in value and hence it is not appropriate for the Exchequer to provide relief. Attractive as this might be at first sight, it fails to recognise that industrial buildings allowances are predominantly for … industrial buildings. These buildings and structures are industrial in nature and will generally have strong planning restrictions. Consequently, in contrast to the increase in value that we have seen for residential property, there has been very little increase in value of the underlying land. Of course, if the land is converted to residential use, the Government's new local planning charge can be used to recapture it, thus avoiding the need for denial of relief in the first place.
- Not a depreciating asset — Another argument is that the relief for maintenance expenditure allows the industrial building to be repaired and maintained such that there is no real depreciation in value. Again, this appears a reasonable argument in principle … until one stops to consider the nature of the buildings under consideration.Consider a factory built 25 years ago. If that was built new today, to the 1983 specification, it would not be fit for purpose. Hence it is clear that the value of the building, even if perfectly maintained, will reduce over time.
Simplification
The simplification agenda, expressed prolifically in the discussion on capital gains tax, is also raised in relation to IBAs. Like the 'expensive car' provisions for capital allowances, IBAs require the identification and tracking of the assets individually, rather than in a pool.
The Government appears to be arguing that this is no longer appropriate and hence the relief should be removed.
Again, there is some truth in the perspective. However, this appears very much a case of 'throwing the baby out with the bathwater' — the fact that the relief is complex should encourage consideration of simplification of the relief rather than outright removal.
Furthermore, there is a clear distinction here between the existing stock of assets, for whom all the calculations have been made, and new investments.
If there is action here, we could expect the introduction of a pool, in the tried and tested manner that has been used for plant and machinery.
The impact
The targets of this change are readily visible, through HMRC's own statistics on industrial buildings allowances. Chart 1 shows how the IBAs are distributed.
It is here that we can see that the notion of a balanced package of rate cut and IBA removal falls apart. Even the former Chancellor noted the danger of such radical changes, when in the 2002 consultation he noted that changes of this nature 'redistribute the tax burden significantly between different sectors in the economy'.
If you consider the infrastructure and transport sectors, for which depreciation on industrial buildings can represent some 30% of their operating costs, it is clear that a two percentage point cut can easily be swamped.
It is also worth looking at the costs identified by the Government. The 'balanced budget' to which the Chancellor refers considers the situation over a three year period and relies on the IBA abolition to generate tax of 0/£75 million/£225 million.
This can be extrapolated over the next few years as: £375 million/£525 million/£600 million, at which point it remains at £600 million a year.
These costs represent the extra cash tax that the Government will receive and, therefore, does not take into account the amount lost to companies that have losses brought forward or surplus losses.
HMRC statistics show the IBAs for 2004 of approximately £3 billion, equivalent to £846 million of tax at a rate of 28%.
Evaluating the phased ownership of IBAs is difficult for anyone other than HMRC to undertake, but it is possible to build a rough model. If we consider that £3 billion of allowances comes from a stock of IBAs build up evenly over the last 25 years, we would expect a stock of £75 billion of assets.
Alternatively, if we consider that the investment will grow evenly on a real basis, i.e. adjust for inflation, we can see an investment profile approaching that in Chart 2.
Given the recent levels of investment, this is likely to be a conservative assumption, but even this will produce a total tax at risk, based on the current stock of assets, of £11.5 billion. This is a very large burden to place on a sector, even if being inflicted over 25 years.
By way of comparison, the last change that the Government introduced affecting such a large stock of tax was the abolition of advance corporation tax in 1997.
At time, the UK had a stock of £7 billion of surplus advance corporation tax and this Government introduced a 'shadow advance corporation tax' regime, on the basis that the removal of such a relief would be unjustified.
With IBAs of the order of £11.5 billion, the same logic can be seen to apply.
Why does it matter?
But, if this was all part of a general reduction in taxes, why does this change matter? The answer to this is that the outcome of the change is clearly disproportionate and impacts a number of taxpayers in a severe manner.
While there are many who will benefit from the cuts in the rate, it serves us well to look at the treatment being provided to this minority, as this could be us in the future.
Furthermore, the changes that are being considered are being applied not only to newly acquired assets but also to assets that have been acquired as far back as 1983.
There is a strong case here that there is a legitimate expectation that the investments would obtain tax relief.
The Government can argue that there would also be an expectation of a higher tax rate but, as evidenced by the discussion regarding the two percentage point cut, that merely serves to obscure the impact rather than to address the inherent unfairness.
The final point of concern stems from the rationale behind the changes — that of producing a competitive tax system. A clear element of such a regime is predictability and certainty.
The denial of relief for expenses committed many years previously is not a sign of an economy that wishes to attract long term investment.
This will serve to undermine confidence in the UK and is completely contrary to the Government's other actions, for example in creating the 'Advance Agreements Unit' which aims to provide certainty to businesses seeking to invest into the UK.
The options
So what could the Government be considering? Well firstly, there is a clear distinction between the position for past and future investment.
Considering past investment, the so called 'transitional regime' fails to fulfil the role of such a policy: it does not provide an easy transition into the new system, but merely delays the denial of relief. It would be far more sensible to introduce a grandfathering provision for existing assets.
Such grandfathering would achieve much of the Government's desired simplification, in that these assets are ones which the companies already hold in their computations, producing the same figure for relief each year. That is a relatively simple calculation.
There has been some concern in the past over the EU state aid rules.
However, the EU rules specifically state that 'measures of a purely technical nature (for example … depreciation rules) do not constitute state aid' and that 'the fact that some firms or some sectors benefit more than others from some of these measures does not necessarily mean that they are caught by the competition rules governing state aid'.
It is, therefore, unlikely that these would be invoked in a grandfathering provision.
Looking forward, there are clear concerns over the creation of yet another tax nothing and a strong economic case for continuing to provide tax relief.
However, the Government has to make difficult choices in where to raise taxes and, at least prospectively the taxpayer has the choice as whether to invest or not.
Conclusion
The proposed abolition of IBAs shares a lot with the proposed changes to capital gains tax taper relief, in being retrospective in nature (even if not in technical and political terms) and seeming to deny a legitimate expectation.
Furthermore, the community affected, this time being the international investor, is very tax literate and will understand the impact. We can expect such investors to be more wary of the UK, precisely at the time when the UK is trying to position itself as a 'great place to invest in'.
At the very least, we should be looking to the Treasury to reconsider the wisdom of this sudden and retrospective change in treatment. So, please do remember IBAs and hope that we can watch our current stock grow old.
Christopher Sanger is head of tax policy at Ernst & Young LLP, a former adviser to the Treasury and deputy chairman of the ICAEW Tax Faculty. Views expressed in this article are personal and do not necessarily reflect those of any of these bodies.
