Capital gains

Income Tax (and corporation tax for incorporated entities) is paid on profits – that is Income less expenses. Understandably there are detailed rules about what expenses can and cannot be deducted for tax purposes. The cost of purchasing a property is not an expense but an asset; hence the purchase is not deductible when calculating profits.

Assets do however have an economic lifespan, some assets have very long lives and others will be worn out in only two or three years. This wearing out of assets is known as depreciation, a legitimate expense that must be taken into consideration when calculating profit. The level of depreciation will depend upon the expected useful life of the asset as well as any residual value and inevitably therefore involves a considerable amount of judgement.

In order to standardise the amount of depreciation that is allowed for tax purposes the legislation disallows all depreciation deducted from income and replaces it with specially calculated sums know as Capital Allowances. The legislation is currently contained within the Capital Allowances Act 2001.

Land and buildings
When a property is bought it will usually involve the purchase of a number of things, the interest in the land on which the property sits, the ‘bricks and mortar’ that make up the building itself and the fixtures, fittings and equipment that are contained within the building. Very often a value will be attributed to each of these elements although sometimes a global figure is negotiated covering everything.

Land does not generally ‘wear out’ so capital allowances are not available to assist in bringing down the cost of it’s acquisition for tax purposes. That is not to say that land cannot fall in value, which of course it can, but simply that the tax system does not provide for the depreciation of land against annual revenues, as it does for other classes of asset.

However, buildings and the assets fitted within them do wear out over time and the tax system recognises this depreciation in a number of different ways.

At its most fundamental level the legislation provides a fixed allowance of four percent of the cost of qualifying industrial and agricultural buildings, however, following the most extensive review of the capital allowances system since the 1980’s, these allowances will no longer be available after April 2011.

More interestingly the 2008 Finance Act introduced the concept of an Annual Investment Allowance (AIA) as well as introducing a new classification of ‘integral features’ of a building or structure applying to new or replacement expenditure. It is in this area, as well as the ongoing allowances for plant and machinery that should be explored in more detail.

What constitutes plant and equipment?
As there is no statutory definition of plant the meaning of the word is to be found in case law. One of the earliest cases on the subject was Yarmouth v France in 1887 which indicated the need for plant to have functionality rather than providing the setting. In contrast moveable partitions were held to be ‘plan’ in the case of Jarrold v John Good & Sons Ltd in 1962.

Later cases provided further clarity and incorporated more detailed tests to establish whether the item of plant appeared visually to retain a separate identity; with what degree of permanence had it been attached to the building; to what extent the structure was complete without it; and to what extent was it intended to be permanent or replaced within a short period.

The legislation is now fairly clear. S21 CAA 2001 defines what is included in a building and is thus not plant. Under the new FA 2008 definition integral features now include the following items: electrical systems (including lighting systems), cold water systems, space or water heating systems, powered systems of ventilation, air cooling or air purification, and any floor or ceiling comprised in such a system, lifts, escalators or a moving walkway and external solar shading. These integral features attract an annual 10 percent allowance.

This still leaves considerable scope to seek a deduction for capital allowances at the 20 percent rate for other equipment and machinery installed in the building including, for example, computer, telecoms and surveillance systems, fire alarm and sprinkler systems, burglar alarm systems and good old moveable partition walls. So how does all this help to save tax?

Expenditure on property
Many purchasers of investment properties get hugely engrossed with the details of the deal and the commercial and legal considerations surrounding it. Businesses that build new or extended premises often agree detailed designs and monitor detailed budgets and then post the costs as simply additions to freehold property in their balance sheet.

In both cases it is essential that very careful consideration is given to allocating costs properly between the land, building , plant, equipment, machinery, integral features and fittings so that appropriate allowances can be claimed. Expenditure in these areas is usually quite high so annual relief at both 10 percent and 20 percent can provide an unexpected bonus from the exchequer.

The opportunity to make the claim can arise on an acquisition and specialist tax surveyors can be used to make a full assessment on behalf of the buyer. Alternatively the buyer may agree to make an election under s.198 CAA 2001 whereby the purchase price of any fixtures identified by the seller will be fixed. It is often not in the buyer’s interest to do this, but he can still conduct a survey to try and locate plant, equipment or fixtures that have been missed after he has purchased the property.

Other allowances
Although they have a more limited application, generous capital allowances are available for the conversion of flats in certain circumstances. This Flat Conversion Allowance (FCA) is intended to encourage the conversion of empty or underused space above shops and other commercial premises to residential use. There are a number of detailed conditions and the building must have been built before 1980, but the allowance is a full 100 percent of qualifying expenditure.

In a similar vein the Business Premises Renovation Allowance (BPRA) was introduced by Finance Act 2005. BPRA is intended to give an incentive to bring derelict or unused properties back into use and also gives a generous initial allowance of 100 percent for expenditure on converting or renovating unused business premises in a disadvantaged (development) area.  The scheme has a life of five years so expenditure must be incurred before 11 April 2012 to qualify.

Finally, it should not be forgotten (as many taxpayers do) that there is still a 10 percent ‘wear and tear’ allowance given against rental income from a residential furnished letting  and HMRC also allow a ‘renewals’ allowance as a viable alternative.

So don’t leave the allowances unclaimed and make sure your property assets are sweated for their tax allowances as well as their rental yield.