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Our client owns a commercial building which was occupied by four tenants. The building was old and required extensive repairs, but this would have proved very costly. After much deliberation, the decision was taken to demolish the property and rebuild it rather than repair the building. Consequently, we believe that the re-development costs should be treated as a capital expense.
The existing tenants were given notice to quit. However, due to various anomalies in their leases, this process entailed legal costs of £25,000 paid to solicitors and compensation costs of £50,000 paid to the outgoing tenants.
The client insists that these costs should be treated as revenue rather than capital in nature so that they would be deductible from the rental income. We have found decisions in tax cases can perhaps go either way.
Readers’ views on this would be much appreciated.
Query 19,351– Demolition Dan.
Reply by ANA
If a property sale is a trading transaction, costs may be revenue.
Demolition Dan does not state what his client’s business is or what will happen to the property when it is rebuilt. If the client is a property developer and the property is to be sold, then the demolition and rebuilding are likely to be a trading transaction, and the legal costs and compensation paid to the tenants will be deductible revenue expenses.
If the client is not a property developer, but intends to dispose of the property once completed, Dan may be able to argue that there is a trading transaction with the property being appropriated to trading stock before demolition. This would give rise to a deemed market value disposal for capital gains purposes under (TCGA 1992, s 161(1)), but an election can be made under s 161(3) to roll over any gain or loss into the profit or loss on the trading transaction. The legal costs and compensation paid to the tenants should then be treated as deductible revenue expenses.
If the client’s intention is to retain the property as an investment, the position is more complex. Ultimately, whether an item of expenditure is capital or revenue is a legal question, and there is no single test to be applied in distinguishing capital from revenue expenditure. Case law indicates that payments by lessees to terminate leases early are capital (see for example Mallet v Staveley Iron & Coal Co (1928) 13 TC 772). There are no equivalent cases on payments by landlords, but the same principles will apply.
A payment in connection with the modification of a capital asset is likely to be capital. It will not be deductible as a revenue expense but should be deductible on the eventual disposal of the property under TCGA 1992, s 38.
If, however, the payment is a rebate or adjustment to rents, it is likely to be revenue in nature. Demolition Dan needs to obtain a copy of all the relevant documentation and confirm the nature of the payment.
Reply by Rob Durrant-Walker
Cases relating to factory chimneys provide guidance here.
HMRC does not accept a notional apportionment between capital improvement and repair. I agree that the development costs are a capital expense. If an asset is entirely replaced, the costs are capital and tax cases around factory chimneys explain the position. In Samuel Jones & Co (Devonvale) Ltd v CIR 32 TC 513, the chimney that was replaced was merely a part of the entirety of the factory, so replacement of the part of the factory was allowed as repair.
In Demolition Dan’s case, the entire asset has been replaced so it cannot be repair. That is not to say that the costs of the new asset are merely added to the capital cost of the old asset for capital gains tax purposes. TCGA 1992, s 24 would determine that we ‘shall’ (not ‘may’) have a disposal event of the old asset as it is destroyed (creating a capital loss). Bear in mind that s 24(3) also says that the taxpayer ‘may’ treat the underlying land as a deemed disposal and reacquisition at its market value. The word ‘may’ suggests optional, confirmed by HMRC’s phrase ‘allows you to’ in its Capital Gains Manual at CG15770, and the benefit to use this option would be to use the loss on the building towards the uplift of the land value.
'As a result, when a claim is made under Section 24(1) or (2), the loss on the deemed disposal of the building or structure will reflect both the fall in value of the building or structure and the change in value of the underlying land. If the value of the land has increased, then there will be a gain on its deemed disposal which will reduce the amount of the loss on the deemed disposal of the building or structure.' (HMRC’s CGT manual at CG15770.)
Are the demolition costs part of the cost of the old asset, or the creation of the new asset? Under GAAP, the cost would be part of dismantling the old long-held asset, so increasing the loss – and such costs would, on the other hand, belong to the new asset if the original had been bought with the intention of demolishing it. For capital gains tax purposes, the demolition costs do not enhance the value of the old asset (TCGA 1992, s 38(1)(b)), and are not part of the incidental costs of making the disposal of it either (s 38(1)(c)) because they do not fall within the specified costs of s 38(2), which are largely professional fees.
Property ‘fixtures’ capital allowances could perhaps have been claimed on the previous building. These can typically be worth between 5% and 40% of the building, but depend on the circumstances and the previous owners’ claim history.
Although we have a disposal of the asset, the trade is continuing so we would not have a balancing event on the pools. Where there is replacement of a plant and machinery asset then for capital allowances purposes demolition costs are added to the cost of the new plant (CAA 2001, s 26). However, although parts of the building have been claimed as plant, the building itself is not plant, and so the demolition costs are not allowable for plant and machinery capital allowances. But, the new structures and buildings allowance (SBA) which applies to new structures, or improvements to existing ones, does include demolition costs, where contracts for construction work are entered into on or after 29 October 2018. Remember that where property capital allowances are claimed, they do not affect the capital gains tax base cost of a property where it is sold at a profit.
There are total notice to quit costs of £75,000. I can see arguments for capital (being related to the demolition of and creation of capital assets), and income treatment (continuity of the business).
Watneys London Ltd v Pike [1982] BTC 288 is a good reference for seeing how some of the arguments run. For example, if there was to be no replacement of an asset then it would be an indicator that the cost is revenue. I err towards the capital treatment of the asset, and so the notice to quit costs will likely be a capital cost but, again, not one that HMRC would accept as falling within s 38(2).
Dan should consider whether there are reasonable grounds for the demolition and notice to quit expense to be treated as costs of creating the new asset. The client must be aware of and accepting such risk, and be prepared to argue with HMRC.
A closer look ...
Reverse surrender of lease
The replies discuss the tax implications of a payment from landlord to tenant. It is not uncommon for a landlord to want a tenant to vacate a property. The landlord may wish to sell with vacant possession, or there might be an opportunity to redevelop an old industrial site for housing. In the past, landlords of commercial property were sometimes keen to persuade longer-term tenants on fixed rents to vacate. It could be worthwhile for the landlord to pay such a tenant to surrender the lease. The landlord could then install a new tenant at a higher annual rent. This means higher income, increased capital value of the property and an enhanced capacity to borrow against it. Further, the higher rent payable by the new tenant could be evidence when the landlord negotiates market value rent reviews with other tenants.
For the tenant, an amount received for the surrender of the lease is a capital sum received for the disposal of a fixed asset – a capital gains receipt for tax purposes. The tenant may deduct the eligible capital gains base cost from the amount received. This would include the capital element of any premium paid for the lease, appropriately wasted according to the table in TCGA 1992, Sch 8. It would also include any enhancement expenditure fulfilling the criteria of TCGA 1992, s 38(1)(b). Any short lease premium relief not claimed because the lease has terminated early is extinguished and is left unclaimed.
One complication with this calculation for the tenant is that if the lease is a wasting asset (50 years or less unexpired at the time of surrender) there may need to be two separate calculations – one covering assets eligible for capital allowances, one covering ineligible assets.
The relevant law is in TCGA 1992, s 47 and TCGA 1992, Sch 8, para 1(6). The calculation can become quite complicated. For a corporation taxpayer, this rule can mean that indexation allowance would be restricted even though there is a gain overall.
The rules in TCGA 1992, s 47 apply only if the asset being sold is itself a wasting asset, such as a short lease. They do not apply to a disposal of freehold land or to the grant or assignment of a lease of more than 50 years. Note also that only enhancement expenditure still reflected in the state of the property at the time of disposal is eligible to be set against the capital receipt.
The landlord making the payment to the tenant for surrender will generally be treated as making a capital payment. This will not be deductible from the profits of the landlord’s property rental business because it involves the acquisition of a capital asset, namely the tenant’s lease, and enhancement of the landlord’s own interest in the land.
The landlord may be able to add the surrender payment to their capital gains base cost for a future disposal. This will depend on the reason for wanting the tenant out of the property.
