OTS review of capital allowances and depreciation November 2017 BPF comments

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1 To: 29 November 2017 Introduction 1. The BPF represents investors in UK real estate an industry which supports more than 1 million jobs and contributed more than 65bn to the economy in 2016, equivalent to 4% of the UK s GVA. We promote the interests of those with a stake in the UK built environment, and our membership comprises a broad range of owners, managers and developers of real estate as well as those who support them. 2. The real estate industry provides the infrastructure and places in which people can live, do business and relax. Indeed, it is very hard to imagine how the modern economy would work if there wasn t anyone to provide it with appropriate physical space. As a creator of that space, the real estate industry is uniquely placed to shape the UK s future and to support long-term economic growth and increased productivity across the UK. 3. We welcome to opportunity to provide comments on the Office for Tax Simplification s review. While we wholeheartedly support the need for simplification of the capital allowances regime, and better alignment of tax relief with incentivising investment; we do not think that transitioning to tax relief based on depreciation will achieve these objectives. Furthermore, it would have an adverse impact on property investment businesses who typically do not apply depreciation to investment properties. We believe that government s objectives would be better achieved by retaining but simplifying the existing capital allowances regime. 4. We outline our general comments below with some further detail included in the appendices as follows: Appendix 1: Response to General consultation questions Appendix 2: Alternative opportunities to simplify the capital allowances regime and better align tax incentives with activity government would like to encourage General comments 5. As an industry, we understand the capital allowances regime well, and while we would agree that simplification of the current regime would be welcome; we do not think that a move to depreciation would result in significant simplification; nor would it increase government s ability to incentivise investment. 6. We have particular concerns in respect of the impact such changes could have on real estate investment as investment properties are typically held at market value in the accounts (and are therefore not depreciated). As a result, a move to tax relief based on accounts depreciation would significantly reduce the amount of tax relief available to real estate investors, which would in turn reduce the amount of capital available for investment in our towns and cities.

2 7. To put this in context; around 35% of costs of a typical office development will qualify for capital allowances. In the case of refurbishments this can be 65-75% given the lower proportion of total costs attributable to structural works. At the current 19% corporation tax rate, removing capital allowances would effectively increase the cost of those works by approximately 7-14%, or perhaps more importantly, reduce the funds available for future development, thus slowing the rate of development. 8. While this is a very rough estimate, it demonstrates how significant the removal of capital allowances could be for the viability of real estate investment and development projects. It would be particularly harmful at a time when the Minimum Energy Efficiency Standards (MEES) will require significant upgrade and refurbishment of commercial buildings from April next year in respect of new leases granted, with the full effect of the new MEES measures impacting on all commercial buildings from While moving to an accounts based regime has its instinctive attractions, it is fraught with difficulty when you get into the detail and we agree with the numerous challenges identified by the OTS in this respect. One of the biggest concerns is that accounting policies change over time and businesses apply them in different ways, which means that rules would result in significant unfairness of tax relief between companies. This is emphasised by the relative lack of scrutiny given to accounting vs tax numbers because of the concept of materiality in financial statements. 10. Finally, it would be very difficult to integrate a capital allowances type regime which incentivises certain investment, with an accounts based regime, without losing the simplification benefits of a wholly accounts based regime. At a time when significant capital investment in real estate and infrastructure and other areas of our economy is required; government should retain the ability to incentivise investment that can help stimulate the economy. 11. However, we appreciate that it is important for business leaders and investment decision makers to better understand this area of tax law the incentives must be instinctive and understandable in order to have an impact on incentivising investment decisions. Therefore, while we would not support a move to an accounts based regime, we acknowledge that simplification of the existing capital allowances regime is needed. To that end, we have suggested alternative means of simplifying the existing capital allowances regime in appendix 2. We would be glad to discuss our comments with you in more detail. Please do not hesitate to get in touch if you require further information. Rachel Kelly Senior Policy Officer (Finance) British Property Federation St Albans House Haymarket London SW1Y 4QX ; rkelly@bpf.org.uk

3 Appendix I: Response to General consultation questions 12. Question 6 - In general, the fewer adjustments to accounts depreciation necessary to arrive at a taxdeductible figure the greater, perhaps, is the potential tax simplification. This implies that assets currently non-qualifying (NQ) for CAs would, if depreciated, qualify for relief. However, some adjustments would be necessary, for example to ensure that capital expenditure would continue to be based on cost (and not on valuation) and to exclude certain assets such as land and dwellings. Please comment on the adjustments to accounts depreciation which you consider may be necessary and yet consistent with delivering simplification. 13. The main benefit of transitioning to a depreciation based approach of tax relief would be simplification. If any re-categorisation of accounting categories would still be required under the new regime, the main benefits of the simplification are significantly eroded. Accounting policies and standards vary across businesses, and accounting standards will change over time. It is important for government to retain some control over what type of investment qualifies for tax relief; and as such, simplifying the existing capital allowances regime would be a better approach. 14. Question 7 - Would a depreciation based approach present issues for income tax returns? 15. The Non-Resident Landlord regime is subject to income tax principles. There may be greater challenges with consistency in application of accounts based rules where overseas businesses are not subject to the same audit requirements, or may use non-standard accounting policies. 16. Question 8 - Overall would the use of accounts depreciation make preparation of the tax return simpler or more complex? What features of such an approach would tend to greater simplicity or complexity compared with the current CA system? 17. See response to question 6 If any re-categorisation of accounting categories would still be required under the new regime, the main benefits of the simplification are significantly eroded. If government would like to keep some control over what qualifies for relief and what kind of investment is incentivised, retaining and improving the capital allowances regime would be a better approach. 18. Question 9 - Would tax compliance costs change if CAs were replaced with a depreciation based approach? By how much? 19. We do not have an estimate for this although we would estimate that tax compliance costs would not change significantly if some categorisation of the accounting categories was still required. 20. Question 10 - The current CA regime has timing incentives for capital expenditure, such as the Annual Investment Allowance (which accelerates tax relief). Assuming such a timing incentive remains desirable, a means of preventing a double deduction (for depreciation and the allowance) would be necessary. Would this significantly compromise any potential simplification benefits of a depreciation based approach? 21. It is not clear how a CA type timing incentives, such as AIA or Enhanced Capital Allowances (ECA), could be easily integrated with a depreciation based regime, without significantly compromising the simplification benefits. We believe that retaining and simplifying the existing capital allowances regime will allow government the most control over how capital investment is incentivised.

4 22. Question 11 - Would there be other impacts of a depreciation based approach, for example the encouragement or discouragement of investment? 23. We have particular concerns in respect of the impact such changes could have on real estate investment as investment properties are typically held at market value in the accounts (and are therefore not depreciated). As a result, a move to tax relief based on depreciation would significantly reduce the amount of tax relief available to real estate investors, which would in turn reduce the amount of capital available for investment in our towns and cities. 24. As indicated in the introduction, the removal of capital allowances could increase the after-tax cost of a typical office development or refurbishment project by approximately 7-14% - which would have a significant impact on viability and on the level of investment available for future development. This would be particularly damaging at a time when the Minimum Energy Efficiency Standards (MEES) will require significant upgrades and capital investment to commercial properties to meet the initial deadline from April next year in respect of new leases granted and by for commercial real estate more widely. 25. The impact on real estate investment trusts (REITs) would be particularly severe given their requirement to pay out a property income distribution (PID) every year. The PID is calculated at 90% of a REIT's taxable property business profits (i.e. after capital allowances). Under the REIT regime, REITs are unable to disclaim allowances and must claim in full each year. 26. The ability to deduct capital allowances is very important as this reduces the required profits to be paid out enabling it to retain cash in the business for future developments. REITs are classed as property investment companies and thus revalue rather than depreciate their properties. A depreciation based regime would force REITs to pay out higher dividends and retain less cash for investment, which will have a negative impact on the attractiveness of the UK REIT market and potentially slow development activity and the associated economic growth. 27. The PID rules are central to the UK's REIT regime, as they ensure that investors receive high levels of income from the qualifying property rental business (PRB), thus providing stable long-term income and certainty for investors. Businesses also need to plan and make investment decisions based on this certainty. REITs are well understood in the investor community and the REIT model is replicated internationally. Any changes to the UK REIT model need to be assessed against our international competitors to ensure UK businesses are not competitively disadvantaged. 28. Question 12 - Should businesses be differentiated by size, or in any other way, when considering whether using accounts depreciation as the basis for relief for capital expenditure would be a simplification? If so, what distinctions would be appropriate? 29. It is not clear how a deprecation based model would easily integrate with a CA based system. For instance, if the two systems were running alongside, but an asset was exchanged between two companies operating different systems, it would be very complex to work out the appropriate tax base. 30. However, we agree that the CA system could be improved by offering simplifications and more generous allowances for small businesses such as SMEs or those that don t meet the VAT threshold or simply continuing with the AIA for annual investment below a certain threshold. Given the AIA is merely a timing benefit, rather than a complete tax break, it makes sense to set this threshold as high as possible. Smaller businesses are less likely to have in house tax specialists and are therefore the business most likely to benefit from this simplification.

5 Appendix 2: Alternative opportunities to simplify the capital allowances regime and better align tax incentives with government policy. 31. There are significant areas of our economy that would benefit from capital investment; and government should not lose the ability to incentivise such investment by implementing an accounts based method of tax relief for tangible fixed assets. 32. We have outlined below some examples of ways to simplify the current CA regime and help direct investment into areas that will help stimulate the economy. Shorter term incentives that adapt to the needs of the economy 33. Government could use CAs as a flexible tool to incentivise certain sectors or where the market is weak, such as: Markets suffering from undersupply and under investment, such as housing or GP surgeries Upgrades to fire safety features in buildings post Grenfell Energy efficiency upgrades to assist with refurbishments to comply with new Minimum Energy Efficiency Standards (coming into force in 2018). 34. Housing is a great example of something that government is trying to encourage investment in and where the existing housing stock is in desperate need of capital investment for repairs and upgrades. At the same time, investors are increasingly interested in residential property, primarily through purpose built rental housing, or Build to Rent (BTR). 35. The government could both incentivise and simplify the tax treatment of such development projects by considering the buildings as a whole for capital allowances purposes rather than requiring the fixtures and fittings to be split out. Under such a system, a percentage of total construction costs could be deemed to qualify for capital allowances. 36. We understand that many similar developments end up claiming a similar levels of capital allowances; so, this could be a radical simplification for more standard developments and refurbishments. However, there will always be projects which are not standard, so it would still be necessary for tax payers to have the option to separately identify qualifying expenditure if they choose to. 37. Depending on the set percentage of deemed qualifying expenditure, this approach could be used to help incentivise investment in certain asset classes suffering from under supply. It would also result in a huge simplification for investment in these assets, because it would not be necessary to split out individual fixtures and fittings. Government could also consider shortening the period over which full tax relief is obtained to further incentivise investment. 38. An alternative suggestion would be to use the AIA more widely to stimulate areas of the market which are in need of some new impetus. Given it is only a timing difference, this could be set at a fairly high level to target the type of investment needed, and made available regardless of the size of the company or level of investment. For example, Xm AIA for those investing in a Build-to-Rent development; or those making upgrades to fire safety features, for example.

6 Energy efficiency - consider buildings and development projects as a whole 39. The capital allowances legislation rightly identifies energy and water saving equipment and features as worthy of incentivisation and this is now more important than ever given the introduction of MEES from next year. 40. Unfortunately, the current ECA rules are quite restrictive in terms of specifically what type of equipment qualifies. This makes it labour intensive to identify what is and is not qualifying and it is not at all instinctive for those making investment decisions For example, investors may use assets with comparable energy/water efficiencies but only gain ECA on one, which leads to confusion and does not seem to meet the aim of the provisions. Additionally, HMRC are more regularly challenging things like LED lighting to ensure the claims are valid and meet the Lumens/Watt criteria details which are not always to hand where sub-contractors have been used or claims are prepared a little while after the construction phase has completed. 41. If the capital allowances regime was aligned in some way with other regulation or existing ways of measuring the energy efficiency of buildings, it would align the tax incentives with regulations or measurements that decision makers are already familiar with and applying in practice. For example, the higher the Energy Performance Rating or BREEAM rating of a building, the higher the tax relief, or the more quickly the writing down allowance for the general pool. 42. This would allow the building to be considered as a whole, rather than requiring the individual energy efficient features to be identified separately which would be a considerable simplification to the Enhanced Capital Allowances rule for whole developments. Smaller businesses 43. We are supportive of targeted reliefs for small businesses as this will generally benefit those that are less likely to have in house tax expertise or afford external advisor services in this field and therefore more likely to struggle with the complexities of the regime. 44. There could be many ways to identify as an eligible business, including: SMEs VAT threshold The annual capital expenditure being below a certain level (i.e. the current AIA). 45. Given the AIA is merely a timing difference, rather than a higher total tax relief, it seems sensible to offer numerous ways for businesses to identify themselves as eligible for total relief in the year of expenditure, to avoid the need to track pools of expenditure.