Base Metal Into Gold

TONY JENKINSON explores how tax relief for remediation of contaminated land applies to trading stock and offers some planning points.

READERS WHO ATTENDED the Harry Potter film will know that the 'Philosopher's Stone' in the film's title is the long sought after substance which turns base metals into gold. It has the handy by-product of producing the elixir of life, providing immortality to the drinker. The equivalent substance in the world of taxation is the formula that turns the base metal of a capital outgoing into the gold of an allowable Revenue deduction. The bonus in this case may not quite be immortality, but a 50 per cent enhancement, for tax purposes, of allowable expenditure would be very welcome. Just such a substance can be discovered, with fewer perils than Harry Potter encountered, in section 70 of, and Schedules 22 and 23 to, the Finance Act 2001.

The relief arises for certain costs of remediating contaminated land in the United Kingdom incurred on or after 11 May 2001. The terms of the relief were ably summarised by Allison Plager in her article 'Where There's Muck There's Brass' (Taxation, 11 October 2001), and this article does not seek to repeat what was said there. Rather, it has two aims: to address the confusion that has arisen over the application of the relief to land acquired as trading stock; and to highlight a number of traps and opportunities for all would-be claimants. Statutory references are to Schedule 22 to the Finance Act 2001 unless otherwise indicated.

Property traders

It is clear that the relief applies to those who acquire land on capital account, whether for the purposes of a trade, for example to build business premises, or to let as part of a Schedule A business. Confusion, however, surrounds the question of whether the relief applies to a dealer or developer who acquires the land on trading account with a view to selling on, perhaps after development. Given that the Chancellor's aim is to make brownfield sites rather less brown, there seems no obvious political reason to favour capital expenditure over revenue.

The original Revenue Budget press release (REV BN22) stated that the relief would 'apply to land acquired as either trading stock, or as a fixed capital asset of a trade or Schedule A letting business'. This was, however, contradicted by the Explanatory Notes on the Finance Bill, which stated (at paragraph 56) that 'the land must have been acquired as the fixed asset of a trade or Schedule A business'. Articles in professional journals have jumped both ways, but I believe that a careful review confirms that the relief is available to the dealer/developer.

The effect of paragraph 1 of Schedule 22, headed 'Deduction for capital expenditure', is that, provided (among other conditions) that the expenditure is capital and is qualifying land remediation expenditure, it will be allowed as a trading (or Schedule A) deduction. Paragraphs 2 to 11 set out the detailed conditions for expenditure to be qualifying land remediation expenditure, but do not include a condition that it should be capital. Paragraph 12 provides entitlement to land remediation relief if land has been acquired 'for the purposes of a Schedule A business or a trade carried on by the company', and the company has allowable qualifying land remediation expenditure in the period, and the next paragraph provides for the 150 per cent relief against income.

Following through the logic of this, it must first be confirmed that expenditure is qualifying land remediation expenditure as set out in paragraphs 2 to 11. Where expenditure is qualifying and is on capital account, it is necessary to apply paragraph 1 to establish that it is allowable as a deduction when incurred. Where expenditure is qualifying but is on revenue account in the first place, it is possible to ignore paragraph 1, and jump to paragraph 12. Since the expenditure is allowable on ordinary Case I principles, it qualifies for land remediation relief. Problem solved: or is it?

Lack of clarity

The confusion seems to arise from the way in which section 70 and Schedule 22 are set out. The draftsman was clearly so excited by the words 'deduction for capital expenditure' that he used them, not only as the heading for paragraph 1, but also as the heading for the whole of Part I, covering paragraphs 1 to 11 and therefore the definition of qualifying land remediation expenditure. This might suggest that such expenditure has to be capital, but that is not borne out by the detail. Ignore the title of Part I and the confusion evaporates. Among the principles of statutory construction that were drummed into me as a trainee Inspector some 20 years ago, one that I still recall was that it is the strict wording of the paragraphs or sections that counts: the titles and headings are meant for guidance only.

This analysis not only confirms that remediation costs qualify for relief where land is acquired as trading stock, but also where land is acquired as a fixed asset, but the remediation cost itself is, on ordinary principles, revenue.

The conclusion is clear, but it requires considerable effort to get there, so it would be helpful if the Revenue would confirm the point and end the confusion. (Editorial note: I wrote to the Revenue for its view last year and have just received verbal agreement that the relief applies to land held as trading stock; written confirmation is to follow.)

Planning points

Seekers of the 'philosopher's stone' of land remediation relief may not have to get past the giant three-headed dog of Hogwarts, but there are plenty of traps, and opportunities, for either the investor or the dealer/developer in obtaining and maximising the relief. The following are my own 'top ten', in no particular order.

Capital or income?

This reversal of the norm arises from paragraph 1, which deems capital expenditure to be allowable when it is incurred, and paragraph 12, which provides land remediation relief when the expenditure is deductible. Capital expenditure will therefore qualify for 150 per cent relief immediately. Revenue expenditure by a dealer/developer will, however, probably form part of the company's trading stock. It only becomes (wholly or partly) deductible when the land in question is either sold or, if a loss is anticipated, written down to net realisable value: in either case, this will often be in a later period. The extra 50 per cent relief is therefore deferred.

Property development groups should consider whether land requiring remediation work should be acquired by a property investment company within the group rather than a dealer. It is a matter of fact and case law whether an acquisition is on revenue or capital account but, in marginal situations, perhaps where no firm decision has been made on whether the land will be retained, the use of an investment company is likely to accelerate the relief. The remediated land can be transferred to a trading company later if appropriate.

Use a company

The relief applies only to companies, unfair as this may seem to individual property investors or developers. Individuals, partnerships of individuals, or trusts may wish to consider buying contaminated land through a company, whether an existing one or one set up for the purpose. There are many other tax implications to be considered here, but other matters being equal, land remediation relief may tip the balance in favour of a company.

Stop the rot!

It is easy to imagine situations where the pollution of land is gradually increasing, for example if chemicals are seeping from some fixed container on the land. There is a nasty trap in paragraphs 1(5) and 12(4) which denies the relief 'if the land is in [a contaminated] state wholly or partly as a result of any thing done or omitted to be done at any time by the company or a person with a relevant connection to the company'. Swift action is therefore needed by the acquirer.

Clearly it is not the intention of the legislation to reward the polluter, and it makes sense that, if the acquiring company has made the pollution worse, relief is denied. The wording is, however, uncomfortably black and white, especially if we focus on the words 'partly' and 'omitted'. It is to be hoped that the Revenue will be pragmatic in such circumstances, but strictly it seems that if the acquiring company delays, even by a short time, dealing with any continuing cause of pollution, all relief will be lost.

Buy land, not shares (if you can)

The relief applies when a company acquires contaminated land. It does not apply if a group acquires the shares of the company holding the contaminated land, assuming that company was wholly or partly responsible for the contamination. It will not help to transfer the land to another group company before the remediation work is undertaken in view of the definition of 'relevant connection' at paragraph 31(3). This is based on the normal connected persons rule, and connection between the claimant and the 'polluter' at any one of three possible times will be enough to deny relief. The three times are:

• at the time of any action or omission which has wholly or partly resulted in contamination;
• when the land was acquired by the claimant, or
• when the remediation is undertaken.

If it is not possible to buy just the land, but commercially necessary to buy the shares of the 'polluter' company, then an elaborate approach may be needed to circumvent these rules. For example, provided that all the pollution occurred before company A joined the group, it would seem possible to acquire the shares of A, and transfer the land to group company B. The group strips out of A any other assets it requires, and then sells or liquidates A. The land is then transferred again within the group from B to C, and C undertakes the remediation work and claims the relief. A and C were not connected either when the contamination took place, or when C acquired the land, or when C undertakes remediation. It appears that C can therefore claim the relief.

Will such an approach fall foul of the anti-avoidance rules in paragraph 29? This covers 'arrangements' which are 'entered into wholly or mainly … to enable a company to obtain' (among other things) a greater deduction, or more land remediation relief, than it 'would otherwise be' allowed or entitled to. A key question is, what is the 'otherwise' with which we are comparing? If the group in the above example had simply acquired the land, it would have got the relief. If it had to buy shares but managed to find a way to get the relief anyway, has it got more than it would 'otherwise' have got? Unfortunately the wording of paragraph 29 is both wide and vague, and the point is not free from doubt.

Find a purchaser

Since the relief is not available to anyone who has contributed to the contamination, either by action or inaction, the vendor may well not qualify. In some cases purchasers will not take the commercial risk of acquiring contaminated land. Where possible, however, the purchaser should undertake the remediation, presumably with the additional cost reflected in the price for the land. (No doubt the vendor will wish the price also to reflect some of the additional tax relief that the purchaser will receive.)

Care is needed when wording the contract. Paragraph 8 precludes relief for expenditure which is 'met directly or indirectly by any person other than the company'. This could presumably apply if the purchase price is shown to be specifically discounted for remediation costs. It is preferable simply to state the price for the land (which inevitably reflects its contaminated state). Similarly, if the vendor provides a warranty or indemnity concerning the land, and subsequently has to meet remediation costs, this will fall foul of the rule in paragraph 8.

Subcontract remediation work

Some property companies may have the in-house expertise to undertake remediation work, and there may be strong commercial reasons for retaining such work. The advantages of using an unconnected subcontractor should not, however, be overlooked.

Where the work is undertaken by the company itself, relief is restricted under paragraph 2(4) to the costs of employees and materials (which excludes items qualifying for capital allowances). It is therefore necessary to track how much of each director's and employee's working time is devoted to such work, and to apportion the wage costs using the rules in paragraph 5. Support staff costs cannot be included. It is similarly necessary to track materials used. There is therefore a considerable record keeping headache. Using a connected subcontractor involves similar restrictions, but may reduce the tracking problem if a group company is dedicated to remediation work.

On the other hand, if an unconnected subcontractor is used, the whole payment for qualifying remediation work is allowed. In effect, all the subcontractor's employee and material costs, plus, for example, its support and administrative overheads, plant and transport costs, will qualify, as will its profit margin. This broader base for 150 per cent tax relief for the owner will often make contracting out more cost effective, and save a mountain of paperwork.

Cash or credit?

Paragraph 14 permits 'unrelieved' losses arising from land remediation relief to be turned into a cash payment by the Revenue. It is assumed that losses will be offset against profits of the same company for the same year for this purpose, but broadly there remains a choice for remaining losses between, on the one hand, claims to carry these back to the preceding year, surrender them as group relief, or carry them forward, and on the other hand, taking the money.

The cash option should not be taken without careful consideration. The cash payment is 16 per cent of the unrelieved loss, that is (with the 50 per cent 'bonus') 24 per cent of the qualifying remediation expenditure. If, however, the losses are carried back, group relieved, or carried forward, then the effective relief (again with the 50 per cent bonus) will be 45 per cent of the expenditure assuming the current full corporation tax rate, or 30 per cent at small companies rate. In many cases, it will be better to wait for taxable profits rather than cashing in the losses.

Identify the harmful substance

The definitions of 'substance' and 'harm' in paragraph 31 seem generously wide, and encompass the great majority of situations which common sense would describe as 'contaminated land'. Nonetheless, it remains necessary to identify the substance (which may be natural or artificial, solid, liquid, gas or vapour) which causes the harm. There are some grey areas. For example would harmful plants such as knotweed, or animal life such as termites, count as substances? Some Revenue clarification on such matters would be helpful.

Quantify the expenditure right away

Only the extra expenditure required to deal with the contamination qualifies for the relief. As a former Inspector, I was expected to be an instant expert in anything that crossed my desk, but I would certainly have struggled to evaluate such a claim. Detailed instructions in the Revenue manuals are awaited, but Inspectors would probably be impressed by a brief report from a specialist environmental surveyor quantifying these additional costs: this would be well worth a small investment.

Consider the landfill tax exemption

The details of the landfill tax exemption for contaminated materials is beyond the scope of this article, and unfortunately it has a different set of conditions from the corporation tax relief. Nonetheless, it will often apply in the same situations. One point to watch is that, while the corporation tax relief can be claimed in a leisurely manner on the year's tax return, the landfill tax exemption needs to be claimed at least 30 days before the removal of the materials begins.

Green objectives

There are some traps, but overall this is a valuable and often generous relief. It is to be hoped that it achieves its aim of providing an incentive to clean up contaminated sites across the country.

Tony Jenkinson specialises in property taxation. He provides a support service to accounting and legal firms, and can be contacted on 01433 631460 and by e-mail at Tony_Jenkinson@compuserve.com.

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