NEW CAPITAL ALLOWANCES RULES FOR
PLANT AND MACHINERY COVERED BY
A LONG FUNDING LEASE
As if the Capital Allowances rules were not already complicated enough, the Government
have decided to impose new rules for deciding who gets Capital Allowances when plant and
machinery is subject to certain types of finance. To this end, the new concept of a “long
funding lease” has been introduced in the Finance Bill 2006 with the effect that lessees get
the benefit of Capital Allowances, rather than lessors. The Government believes that the new
rules will “remove a distortion in the current system caused by the differing tax treatment of
Stephen Winter finance from different sources”.
Chair of Internal
There has been much complex legislation concerning finance leases in recent years and it is
tempting to view the rules on long funding leases as a continuation of the assault by the Government on the
leasing industry. The new legislation does not just cover plant and machinery on finance leases, it covers plant
and machinery on operating leases as well. Furthermore, plant and machinery leased with a building is
potentially covered by the new rules. It is not, therefore, surprising that the property industry is expressing some
apprehension about this legislation.
The new regime for plant and machinery leased on a long funding lease is set out in Schedules 8 and 9 of the
Finance Bill 2006 and will apply to new leases finalised on or after 1 April 2006, or where the commencement of
the lease term is on or after that date, subject to so called “grandfathering provisions”. The schedules make
amendments to the Capital Allowances Act 2001 (CAA 2001), the most important for the property industry being
Section 34A which states “Expenditure is not qualifying expenditure if it is incurred on the provision of plant and
machinery for leasing under a long funding lease”. So what is a long funding lease? To answer that question
one needs to work through definitions of a funding lease, a plant and machinery lease, a derived plant and
machinery lease and an excluded lease of background plant and machinery.
Rather than wade through the legislation it is probably easier to summarise what is not a long funding lease and
then review the problem areas that will arise under the new legislation. The following will, therefore, not be a
long funding lease:-
1) Short leases of less than 5 years and in certain cases less than 7 years (s70I).
2) Hire purchase contracts (as these are not accounted for as leases).
3) PFI contracts (as these are not accounted for as leases).
4) An excluded lease of background plant and machinery (s70R)
5) A lease of plant and machinery with low percentage value leased with land (s70U).
Excluded Lease of Background Plant and Machinery
This represents the Government’s attempt to exempt property leases from the new rules. An excluded lease of
plant and machinery applies where the plant and machinery is leased with the property, rather than separately
and “is any plant and machinery”…..
a) “which is of such a description that plant or machinery of that description might reasonably be expected to
be installed in, or in or on the sites of a variety of buildings of different descriptions, and”
b) “whose sole or main purpose is to contribute to the functionality of the building or its site as an environment
within which activities can be carried on”.
The Finance Bill does not set out specific examples of background plant and machinery, but Section 70T gives
the Government power to make orders relating to background plant and machinery. The technical note on
leased plant and machinery dated 31 March 2006 issued by HM Revenue & Customs did include an illustrative
list of background plant and machinery, which consisted of items of internal finishes (including items like
demountable partitions and signage) and the normal services items such as heating, hot water, sanitary
appliances, electrical installations, etc.
It would, therefore, appear that chattels are not envisaged to be background plant and machinery. Neither are
trade fixtures, such as hotel swimming pools, gantry cranes in industrial buildings, medical equipment in
hospitals, or any other type of plant and machinery that would not be found in most types of buildings. If,
however, an item of plant and machinery is not background plant and machinery it might still escape the new
rules if its value falls within the exclusion for low value plant or machinery leased with land.
Plant or Machinery Leased with Land; Low Percentage Value
It is difficult to understand what the Government wanted to achieve with this section (s70U) of the legislation,
because all plant and machinery leased with a property could have easily been excluded by widening the
definition of background plant and machinery. Any item that is not background plant and machinery will still be
excluded if it meets both the following conditions at the commencement of the lease:-
a) Does not exceed 10% of the value of the background plant or machinery and
b) Does not exceed 5% of the value of the property.
In the case of a hotel, the FF&E could easily exceed one or both the above limits and would then potentially be
caught by the new rules, in which case the lessor would not get Capital Allowances and they could be available
for the lessee to claim.
The lessee must prove that the lessor and any superior lessor is not able to claim Capital Allowances before a
claim by the lessee can be successful. This is to ensure that there are no double claims, i.e. two persons
claiming Capital Allowances on the same plant and machinery at the same time. In the case of a hotel
swimming pool, for example, even if the value of the swimming pool exceeded the deminimus limits set out
above, the lessor would still be able to claim industrial building allowances on the swimming pool as part of a
qualifying hotel building. The lessee would not, therefore, be able to claim Capital Allowances on the swimming
pool, but the lessor would have to be content with 4% per annum straight-line writing down allowances, rather
than 25% on a reducing balance basis for plant and machinery allowances.
It is unlikely that there will be any plant and machinery fixtures covered by a normal property lease that will fall to
be treated as being leased under a long funding lease. That is because either it will be treated as background
plant and machinery, or it will be excluded by the low value limits. Even so, the property industry is currently
lobbying for the low value limits to be increased to 20% and 10% respectively.
The position for chattels leased within property does not look so clear cut. In the case of FF&E in a hotel that
breached the low value limits, the lessor would not be able to claim industrial building allowances as the chattels
are not part of the hotel building. But would the chattels fall to be covered by the provisions for long funding
leases? To decide this we need to consider the tests for being a funding lease. If the chattels meet any of the
three tests for being a funding lease, then the lessor may not be able to claim Capital Allowances.
These three tests are as follows:-
1) The finance lease test (s70N).
2) The lease payments test (s70O).
3) The useful economic life test (s70P).
The Finance Lease Test
A lease meets this test if the lease is one which, under general accepted accounting practice, would fall to be
treated as a finance lease. This test, therefore, follows the accounting treatment of the lease and should be a
matter of fact rather than opinion. Most property leases would not be treated as finance leases, so chattels
within a property will not meet this test.
The Lease Payments Test
A lease meets the lease payments test if the present value of the minimum lease payments is equal to 80% or
more of the fair value of the leased plant or machinery. In the case of chattels included in a property lease, this
test will require an apportionment of the rent. Assuming a yield of say 6% apportioned equally over all
components of the property, this test is likely to be met on leases of 24 years or more. If the yield dropped to
say 5%, then the lease would need to be 29 years or more. Therefore, chattels in hotels on leases of no more
than 20 years are not likely to get caught by this test.
The Useful Economic Life Test
A lease meets the useful economic life test if the term of the lease is more than 65% of the remaining useful
economic life of the leased plant or machinery. If we assume that most chattels leased with buildings would not
have a useful economic life of over 10 years, then this test is likely to be met on all property leases that are not
excluded as short leases.
It is, therefore, very likely that chattels leased with properties such as hotels, nursing homes, public houses, etc,
would fall to be treated as leased on long funding leases. This could result in the lessor claiming Capital
Allowances on the fixtures, but only the lessee would have the right to claim Capital Allowances on the chattels.
In such circumstances, would lessors still want to fund the cost of the chattels as part of a property investment?
Tax Effect on Lessor
If any plant and machinery is treated as leased on a long funding lease then the lessor will not get plant and
machinery allowances. The lessor might still get industrial building allowances if the plant and machinery is a
fixture within a qualifying industrial building or hotel. If the long funding lease is an operating lease, the lessor
will be taxed on the rents received less the reduction in value of the plant and machinery during the term of the
lease. This amortisation is assessed at the start of the lease. Therefore, the lessor loses Capital Allowances,
but gains amortisation.
If the long funding lease is a finance lease then the lessor is taxed only on the finance element of the rents (the
balance is treated as loan repayment), but does not get any amortisation as the plant and machinery is treated
as owned by the lessee.
It is unlikely that long funding leases will apply to plant or machinery leased with offices, retail or industrial
properties. However, properties that are leased with a high value of trade fixtures might be caught by the new
rules if the plant or machinery is not background plant or machinery and the value of the items exceeds the
deminimus limits for non background plant or machinery. It should also be noted that chattels do not benefit
from the exclusions for background plant or the deminimus limits. As previously stated, these new rules might
therefore be particularly relevant to the FF&E content of a new hotel investment. In such circumstances, the
investor may want to consider how the cost of high value trade fixtures and/or chattels are funded.
Perhaps one solution to the problem of having chattels treated as leased on a long funding lease would be to
make sure the chattels are not leased at all? The lessee could pay for the chattels under a separate agreement
and the lessor could contribute to the full cost of the chattels. The lessee would then own the chattels outright,
the lessor would get Capital Allowances under Section 538 of CAA 2001 and the returns from the investment
would be unaffected. However one would have to be mindful of UITF 28 and if the contribution was accounted
for as a reduction in rent then the contribution would not attract capital allowances.
Another solution is to lease the chattels on a separate short lease and even take advantage of the short life
asset rules by disposing of the chattels to the tenant within 4 years. This would have the effect of accelerating
the capital allowances available to the lessor.