Replies to Queries -- 3 - The disadvantages of letting

Replies to Queries – 3

The disadvantages of letting
IR150 (Taxation of rents: a guide to property income) contains various comments on what are capital and revenue expenses.
I am troubled by paragraphs 213 and 214 on professional fees. Paragraph 213 essentially says fees are capital if they relate to a capital matter, such as the purchase of a property. Paragraph 214 then says 'The expenses you incur in connection with the first letting … of a property for more than one year are capital expenditure and are therefore not allowable. The expenses include, for example, legal expenses (such as the cost of drawing up the lease), agent's and surveyor's fees and commission. Expenses for a let of one year or less can be deducted'.
Under the pre Finance Act 1995 régime, paragraph 5120 of the Revenue's Property Income Manual stated 'In the case of a first letting the incidental expenses are strictly capital expenditure. In practice, however, normal expenses incurred in connection with the initial letting or sub-letting of a property, for example legal expenses, agent's and surveyor's fees, commission, etc., may be allowed unless the letting is for a term which exceeds 21 years'.
Do readers agree with the Revenue's interpretation of the first letting expenditure as capital expenditure and the apparent change of practice from 21 years to 1 year? How far does that interpretation of capital expenditure extend; does it extend to advertising expenses for the first tenant, costs of drawing up plans of the lettable space, etc.?
If the Revenue's interpretation is correct, do readers agree that at the end of, say, a five year lease where the tenant does not renew his lease, this initial expenditure disappears into oblivion and would not be an allowable deduction in any future capital gains tax computations on disposal of the property?
(Query T15,758) – Skyscraper.

'Skyscraper' is correct in that there has been a clear change of practice in this area. The new edition (June 1997) of the Inland Revenue's Property Income Manual states at paragraph 5120:
'This (old) guidance on legal expenses reflects our long standing practice under the old Schedule A. Under new Schedule A for income tax cases, where Case I principles now apply, our practice is different.'

Whether such a change can be justified is another matter. Section 21A(1), Taxes Act 1988 states that 'except as otherwise expressly provided, the profits of a Schedule A business are computed in the same way as the profits of a trade are computed for the purposes of Case I of Schedule D'. So the point at issue is whether the costs of setting up the first lease on new property is capital or revenue expenditure under Case I rules.
The Inland Revenue takes the view that the granting of a lease is a transfer of part of the owner's interest in the property in that he no longer has the right to occupy it himself. It concludes that, in the case of a first letting, this makes the incidental expenses capital in nature. But there seems little justification for this on Case I lines.
If one considers the case law on the distinction of revenue and capital expenditure, one returns to the dictum in Atherton v British Insulated & Helsby Cables Ltd 10 TC 155. Expenditure was normally capital if it was 'made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of the trade'. If the lease is only going to last just over a year, it is hardly 'enduring'. This may well have been the reason that 21 years was taken as a suitable interval under the old Schedule A rules.
I do not see that any distinction can be made merely because the owner is 'giving up his right to occupy the property'. A trader gives up his 'rights' to do other work when he enters an exclusive contract. Traders, like landlords, may have several contracts/lease agreements running at the same time or just the one. The legislation does refer to the running of a Schedule A 'business', and the granting of leases and the acquisition of tenants should been seen in this light. The landlord wins and loses tenants just as the trader wins and loses contracts (Kelsall Parsons & Co v Commissioners of Inland Revenue 21 TC 608).
There also seems little justification for distinguishing between the initial lease and subsequent leases. When traders begin to trade, the Revenue does not attempt to disallow the costs of the first contracts whether they are for income or expenses. In fact one of the only cases where the courts agreed that payments in respect of a contract were capital in nature was Van den Berghs Ltd v Clark 19 TC 390, the conclusive argument in the case being that the agreement 'related to the whole structure of the company's profit-making apparatus', and formed 'the fixed framework within which its circulating capital operated'.
There have been plenty of cases where the Atherton dictum has been followed, for example in Jeffs v Ringtons Ltd [1985] STC 809 there was an advantage to the company in setting up the fund, but the payment could not be said to have created or acquired for the company an asset or enduring advantage of a capital nature. It appears that similar arguments could be used by 'Skyscraper' in challenging this change of practice and interpretation of the new Schedule A rules. Without such a challenge he/she is correct in concluding that, even with a lease renewal, the initial expenditure disappears into oblivion and becomes one of the all too familiar 'tax nothings'. – Mater.

With the move towards self assessment, changes were made in 1995 to the Schedule A income tax rules 'to simplify a complicated area of tax law' so as to make it easier to compute income from property and to assess it under the new régime (Revenue press release, 29 November 1994). The new Schedule A rules treat property income as a 'business carried on for the exploitation, as a source of rents or other receipts, of any estate, interest or rights in or over land in the United Kingdom'.
As the owner of property situated some distance from where I reside, I have always felt that the Revenue shows an excessive willingness to challenge the income from property and, in particular, the deductions which can be made. I have also noted that the willingness to challenge items is seldom supported by technical knowledge or a sound argument which might support the Inspector's contention. Legal and other professional expenses are liable to be challenged at any of the three hurdles which an outlay must surmount before it is deductible: an expense may be regarded as attributable to capital; it may be regarded as not wholly and exclusively laid out for business purposes; or it may be seen as referable to the application of profits already earned.
Over 50 years ago, Lord Porter declared:

'No directions are given in the Income Tax Acts as to how [business] profits are to be ascertained, and in default of direction they must … be arrived at on ordinary commercial principles, subject to such provisions of the Income Tax Acts as require a departure from such ordinary principles … ' (Absalom v Talbot 26 TC 166).

There is, broadly, no distinction to be drawn between companies on the one hand, and unincorporated businesses, partnerships and sole traders on the other, in applying these general principles. The treatment in the statutory accounts generally makes it much more difficult to argue a case for alternative tax treatment. A particular point of concern raised by the Tax Faculty of the Institute of Chartered Accountants in England and Wales was whether the taxpayer could submit a tax computation reflecting a more prudent view than had been adopted in the accounts.
The question of whether expenditure is capital or revenue for tax purposes is one of tax law. It follows that expenditure which is revenue for tax purposes does not, and cannot, lose that character whether or not it is charged wholly in one year's accounts, or spread over the accounts of more than one year. In other words expenditure does not become capital expenditure by being 'capitalised'; 'capitalised' revenue expenditure is still revenue. There was a clear statement of this matter in the Inland Revenue's Assessment Procedures Manual at paragraph AP1640 (now deleted) which stated:

'The granting of a lease is a transfer of part of the owner's interest in the property in that he no longer has the right to occupy it himself. In the case of a first letting the incidental expenses are strictly capital expenditure. In practice, however, normal expenses incurred in connection with the initial letting or sub-letting of a property, for example, legal expenses, agent's and surveyor's fees, commission, etc., may be allowed unless the letting is for a term which exceeds 21 years.
'Where a property is re-let, similar expenses may be allowed, except where the new letting is for a term which exceeds (or may at the lessee's option exceed) 50 years.'

The article at page 375 of the December 1996 edition of Tax Bulletin makes it clear that the new régime introduces a new treatment. In practice and in strict law, the legal expense on the first letting is capital, but what is equally clear is that the Revenue will generally accept the accounting treatment. If the amount is not material and so is not capitalised, the Revenue will accept the treatment.
Advertising costs are not treated as capital costs and so they would normally be allowed. Drawing up plans for the lettable space would be a grey area, but on balance they should be expensed and allowed.
If legal fees have been capitalised, the conclusion of the lease will result in the fees being worthless and not being reflected in the asset. They would become a nothing, denied relief on disposal and not allowable against income. For this reason, it is not good practice to capitalise the expense and if the Revenue challenges the expense it is useful to refer to the new instruction mentioned above at paragraph AP1640. Whether by concession or pragmatism, the Revenue does not take the point further and will generally allow the expense on a without prejudice basis. – Bungalow.