Cost model: Property taxation

<B><FONT SIZE=”+2”>Introduction</FONT></B>The wide range of factors affecting a development project can influence the application of tax on property expenditure. However, the total tax burden can be reduced through careful initial planning, documentation, working methods and procedures. In addition, allowances and deductions, which can be set against corporation or income tax, also provide a valuable benefit in the form of tax relief for commercial organisations that choose to invest in property.
Taxation is never a black and white issue and, as is often the case, opportunities to reduce tax burdens and increase tax allowances and deductions can arise within the grey areas. Those wishing to legitimately avoid tax can refer back to the case of IR Commrs vs Duke of Westminster (1936), where it was stated that everyone “is entitled, if he can, to order his affairs, so that the tax attaching under the appropriate acts is less than it would otherwise be”.
This article gives a general overview of the taxation issues that affect property and construction, together with a more detailed look at the subject of taxation allowances and deductions.

<B><FONT SIZE=”+2”>Property taxation issues</FONT></B>Tax impositions on property expenditure are generally limited to Stamp Duty on land and property transfers; landfill tax; and VAT on the supply of goods and services. Their effects are summarised here:

• Increases in Stamp Duty on land and property transactions of more than £500 000 to 3.5%, introduced in the 1999 Finance Act, have led to landowners considering differing methods of transferring ownership, such as trading in property shares, which attract a lower rate of duty.

• Landfill tax, introduced in 1996, is a green tax aimed at discouraging the disposal of waste to landfill sites. The rate for active waste, currently £10/tonne, is set to increase by £1/tonne every year until 2004-5, at which point the tax rate will be £15/tonne. Landfill tax can be reduced by on-site disposal or use, the sorting of active and non-active waste, disposal of waste other than by landfill, and reuse of waste elsewhere. Exemptions are available for certain specified operations such as dredging, as well as the disposal of waste from historically contaminated land.

• Value-added tax was known as “the simple tax” when it was introduced in 1973. Unfortunately, it has become increasingly complicated, particularly when applied to property expenditure. The combination of complex legislation and the high value of transactions means that an incorrect assessment in the calculation of VAT liabilities can be very costly. In addition, a constant stream of court and tribunal decisions means that a moving target is set for advisers aiming to determine the VAT liability of property-related activities.
• Generally, construction works are standard-rated. However, the construction of new dwellings or approved alterations to scheduled monuments and listed buildings when used for relevant residential or charitable purposes are all zero-rated for VAT.
• The ability to zero-rate items of work or reclaim VAT are the main methods of reducing the impact of the tax. This has led to a thriving business related to the development of financial structures designed to avoid or delay the impact of VAT. These, in turn, have themselves been the subject of attack by Customs and Excise, through changes to legislation designed to close loopholes.

• Energy taxation The government’s commitment to the reduction of CFC gases, which contribute to the greenhouse effect, presents the prospect of an energy tax, which is likely to be introduced in 2001. It is intended to penalise high-energy users.

<B><FONT SIZE=”+2”>Taxation allowances and deductions</FONT></B>Taxation allowances – the allowable income that is free of tax – are provided as an incentive to encourage investment in, and maintenance of, assets used within a company’s business or trade. They are available for investment in commercial buildings, but do not generally apply to residential property. Taxation allowances are a right and are available to all claimants that can demonstrate entitlement.
A claim establishes the maximum level of benefits that can be passed on to a purchaser for the items claimed, and as a result, the failure to maximise the available tax allowances at the outset can reduce the end-value of a property.
Capital allowances are defined by the Capital Allowances Act 1990 and the resultant case law. The table on the right sets out the main allowances available within commercial property expenditure. Revenue-deductible expenditure, which can be deducted from a company’s profit and loss account, is defined within the Income and Corporation Taxes Act 1988 and more case law.
The most lucrative tax benefits will arise where 100% initial allowances are available. In these instances, the effect of the allowances for a 30% taxpayer will be to reduce the project cost by 30%, albeit with these savings being recovered in arrears.
At the other end of the scale, qualifying industrial buildings (which include qualifying hotels) attract a 4% annual allowance for 25 years on the cost of the works. On this basis, a £10m expenditure at a 30% tax rate will attract a yearly tax saving of £120 000. It is important to claim the more valuable allowances (such as machinery and plant) before allocating the remainder of expenditure to industrial building allowances, in effect maximising the value available to the client.
The expenditure on construction that is allowable or deductible, and the value of the allowances, are influenced by several factors: the Capital Allowances Act 1990 and the Income and Corporation Taxes Act 1988; the case law; the type of work carried out; the specification of works; the type of client organisation; the client’s tax position; the client’s tax rate; project funding arrangements; grants and contributions; the use of the building; the type of tenant; the timing of the claim; previous claims and restrictions; and negotiations with the Inland Revenue.

<B><FONT SIZE=”+2”>Capital allowances for machinery and plant</FONT></B>The main area of work for property taxation specialists centres around claims for expenditure on machinery and plant. The value of this work is written down at 25% on a reducing balance basis. This provides a front-loaded tax recovery, where 76% of the allowances are written down after the fifth year and 94% after the 10th year. However, because of the multiplicity of case law focused on the exact definition of machinery and plant, it is difficult to generalise about what is allowable.
“Machinery” can be simply defined as mechanical equipment with moving parts or an assembly of interconnected components. An air-handling unit or a lift would qualify, for example, as machinery. However, the definition of “plant” in any particular instance is more elusive, potentially resulting in a lengthy consideration by tax specialists, the Inland Revenue and the legal profession. A general guide was provided by Lindley LJ, in the case of Yarmouth vs France, 1887, where Lindley suggested that plant could be defined as “whatever apparatus is used by a businessman for carrying on his business - not his stock-in-trade, which he buys or makes for sale; but all goods and chattels, fixed or moveable, live or dead which he keeps for permanent employment in his business”. Since then, a number of legal tests have been developed that can be applied to determine what is allowable.

<B><FONT SIZE=”+2”>Work in existing buildings</FONT></B>Within the the Capital Allowances Act 1990, specific references have been included to allow, or define, items of plant in certain cases. Two of these areas worth highlighting are section 66, which refers to works “incidental to” the installation of machinery and plant in existing buildings, and section 69, which refers to work required by a notice issued in connection with the Fire Precautions Act 1971. Both refer to works to an existing building, rather than works in connection with new construction. They also extend the scope of allowable expenditure where works are carried out on existing property.
Refurbishment often involves extensive builder’s work related to new installations. For example, the introduction of air-conditioning installations within an existing property may include the formation of new plant rooms, duct risers, holes, floor-strengthening for plant, adjustment of ceiling levels, and so on, associated specifically with the new system. As works “incidental to” the installation of an item of machinery and plant, they can be claimed as part of the installation. Works required pursuant to a notice under the Fire Precautions Act 1971 could include the creation of additional escape staircases required when converting an existing property to a hotel. This could involve provision of new foundations, stair structure, balustrades and finishes; enclosing walls and roofs; formation of holes for escape doors, strengthening the structure, formation of internal fire lobbies and associated fire doors. All these items, where they legitimately form the works in connection with the notice, can be brought into the valuation of the allowable works.
<B><FONT SIZE=”+2”>Revenue expenditure</FONT></B>Revenue-deductible expenditure, incurred when working in an existing property, can be offset against a company’s profit and loss account. However, for this claim to succeed, it is necessary to demonstrate that the property was in beneficial use and generating income before any refurbishment was carried out. Where the works are carried out on a newly purchased vacant building, they are likely to be considered as improvement required to create beneficial use.
Works of a revenue nature will include repair and maintenance work plus like-for-like replacements. So, repairing cracks, cleaning down, redecorating, structural repairs, overhauling existing items and replacing items with those of a like nature can be considered revenue-deductible items. Where an item involves an element of improvement, it will not qualify for revenue-deductible expenditure.
Where claims for works in existing buildings are concerned, the quality of the documentation can be crucial in supporting negotiations with the Inland Revenue. A claim for a like-for-like replacement may be difficult to justify as revenue expenditure if, for example, an item for replacing a suspended ceiling is split between “take out existing” in one section of the documentation and “new suspended ceiling” in another, where no connection is established between them. Similarly, the associated works in connection with an allowable installation could be usefully established under a single heading such as “works in connection with new fire escape staircase”.
When the full range of opportunities for claiming capital and revenue expenditure are considered, it is often said that, from a tax efficiency viewpoint, the purchase and refurbishment of existing buildings may be cheaper than new-build construction. However, the ability to realise the site’s full development value through new build may far outweigh the benefits offered by the tax savings associated with refurbishment.

<B><FONT SIZE=”+2”>Design and other considerations</FONT></B>On many projects, early consideration of tax-efficient design solutions will enhance the overall value of any eventual machinery and plant claim. For example, the specification of an air-conditioning system to include a plenum suspended ceiling or raised floor will enable these items to be added to the value of a capital allowances claim. Capital allowances should also be considered as part of whole-life costing exercises, when appropriate, as the cash benefits of the allowances will occur in the years following the initial capital expenditure. A range of options can be effectively compared on the basis of a net present value.
It is also possible to look at project funding to consider the position of the property investor and the building user. The costs of shell and fit-out works can be apportioned to maximise the allowances for the party best placed to benefit from the allowances.
<B><FONT SIZE=”+2”>Environmental impact</FONT></B>Commentators on green issues have noted that capital allowances act as an incentive to invest in high energy-consuming M&E installations, such as air-conditioning. This incentive is clearly not consistent with the government’s objective of reducing energy consumption and greenhouse emissions. However, low-energy mixed-mode cooling installations and building energy management systems, which reduce energy consumption, often have a high initial capital cost and also benefit from capital allowances. In certain cases, elements of the building structure that can form an essential part of passive cooling and ventilation systems, such as a raised floor plenum, automatic window openers or a borehole for water cooling, can be included in the value of associated allowable items.
<B><FONT SIZE=”+2”>Preliminaries and professional fees</FONT></B>Additional costs can also be attributed to allowable items in a capital allowance claim. Preliminaries items related to the contractor’s administration and supervision of the works are not usually specific to any item or items of work, being equally applicable to all.
Professional fees can either be specifically related to certain types of work, such as structural or mechanical and electrical engineering, or cover all aspects of the works, such as project management, architecture or quantity surveying. These cost headings can be added to the value of associated machinery and plant. The cost of claims for loss and expense related to the disruption and prolongation of the contract works can also be claimed if a relationship between the claim and allowable work can be established.
Additional costs, such as the cost of finance, are considered too remote by the Inland Revenue to qualify as an associated cost in connection with the allowable items.

<B><FONT SIZE=”+2”>Conclusion</FONT></B>As with all taxes, when large sums are at stake, avoidance becomes a major consideration for both taxpayers and government. The continual need to review taxation rules, either for political ends, or in an effort to close apparent loopholes, can often bring about inconsistencies, over-complicating what were originally simple proposals. For this reason, specialist advice on tax matters is particularly valuable to property clients.
A particular attraction of capital allowances and deductions is that the savings achieved can be clearly seen as a reduction in a client’s tax bill. Consideration of tax allowances and deductions should always be undertaken before entering into any agreement for property expenditure, as they can often provide significant benefits to the client that may otherwise be lost or reduced if appropriate and timely action is not taken.
In general, the cost of the specialist advice is repaid many times over by the savings that can be generated.

<B><FONT SIZE=”+2”>Cost breakdown</FONT></B>The cost breakdown is based on the refurbishment and fit-out of a notional 12-storey city-centre office building with a gross internal floor area of 14 500 m2. The refurbishment involves demolition and limited repair works, together with the total replacement of external cladding, most finishes and all the mechanical and electrical installations. The fit-out includes partitions, additional services and flood wiring, but excludes tenant’s furniture, IT, communications systems, and other furniture, fittings and equipment.
The cost breakdown identifies the items of building and fit-out work that are eligible for tax relief, either as revenue expenditure or by qualifying for capital allowances. The breakdown shows that the total value of the refurbishment works that attract tax relief is £9 090 600, equivalent to 56.4% of the contract value. The net present value of the benefit of the tax relief, based on a discount rate of 8% and a corporation tax rate of 30%, is £2 066 000. Similarly, the total value of fit-out works that attract tax relief is £2 374 800 – 77.2% of the contract value. The net present value of the benefit of the tax relief for the fit-out works is £539 700.
Items that qualify for tax relief are marked “yes” in the cost breakdown. Only items with established definitions, as either revenue expenditure or machinery and plant, are included. Contentious items, such as revolving doors, toilet cubicles, IPS systems, general small power installations or earthing and bonding, are not included in the totals of qualifying expenditure.
Costs are current in November 1999, based on a location in outer London. The level of pricing assumes procurement on the basis of a lump-sum contract with elements of contractor’s design. Adjustment should be made to the costs to account for variations in phasing, specification, site conditions, procurement route, programme and market conditions.