Taking a lease of new premises can be a costly business for a tenant. Not only is the first rent payment normally payable in advance, before the tenant has started earning income from the property, but there will also be start-up costs for the business, including the cost of fitting out the premises to the tenant’s personal requirements.
A landlord will, therefore, sometimes offer an incentive (by way of a rent-free period or a cash contribution) to the tenant to take the lease. The question then arises as to how the incentive will be taxed. Particular difficulties can arise where the inducement payment is linked to the tenant carrying out works, in which case the treatment here will depend on the nature of the works.
No works involved
Tax on income and gains
A cash contribution is likely to be treated as a capital payment for the landlord but as income for the tenant (under the “reverse premium” rules). A rent-free period will reduce the landlord’s income and reduce the tenant’s tax deduction in relation to the missing rent.
Following the Mirror Group case, HMRC accepts that a pure cash inducement (to take on the obligations under the lease) is not a payment for a “supply” and is, therefore, outside the scope of VAT.
The key element here is that the payment must be a pure inducement and must not relate to any other supply by the tenant. However, for example, an anchor tenant agreeing to help market and advertise a new shopping centre may be treated as the provision of marketing/advertising services by the tenant and, therefore, be subject to VAT.
Contributions to tenants’ works
If the landlord is providing a property in what is sometimes referred to as “white box” or “shell” state – where the works being carried out by the tenant are purely tenant’s fitting out works – the position should be relatively simple. The expenditure is solely for the benefit of the tenant – so the tenant is not treated as providing any service to the landlord.
Tax on income and gains
Sometimes, landlords making contributions will wish to claim capital allowances (“contribution allowances”) in respect of the expenditure – where the tenant allows the landlord to claim allowances, the reverse premium rules will not apply. The tenant will not be taxed on the receipt as income and the landlord will be able to claim capital allowances on the expenditure.
The tenant is not providing a service, so the payment is outside the scope of VAT.
Contributions to landlord’s works
A landlord may deliver the property to the tenant as a bare shell, without all of the works that a landlord would ordinarily carry out having been completed, leaving it to the tenant to complete the landlord’s works. This can be cost effective because it saves the landlord the cost of “over-finishing” the building, only to have the tenant strip back parts for the tenant’s works. It also allows the one contractor to complete the works and enables the tenant to tailor the property better to the tenant’s personal requirements.
However, this will complicate the tax treatment because the tenant will be treated as having entered into a contract with the landlord under which the tenant will carry out the Landlord’s works.
Tax on income and gains
As with any other building contract entered into by the landlord, the landlord will be entitled to capital allowances and the tenant, as a “building sub-contractor” will be taxed on any profit margin it makes on the works.
The tenant will be providing construction services and so will need to charge VAT (for a new business, this may accelerate the time at which the tenant becomes required to register for VAT).
Construction Industry Scheme (“CIS”)
The direct tax and VAT treatment is relatively easily managed. Far more significant is that, as the tenant is carrying out “construction operations” it will be treated as a “sub-contractor” for the purposes of the CIS. If the landlord is a contractor (either because it is a property developer, or it is an investor that spends more than an average of £3m over 3 years on construction operations – so is a deemed contractor), the CIS will operate in relation to payments for the works being carried out.
This can cause major cash-flow problems for the tenant. If the landlord makes deductions from payments to the tenant, the tenant may not have sufficient cash to pay its sub-contractors (who are actually carrying out the work) and who may be registered to receive payment without deduction (“gross payment”). A simple solution may appear to be for the tenant to register for gross payment itself; however, it takes time to register.
More significantly a business needs a record of good tax compliance and a history of carrying out construction operations before it can register. For a tenant that has no interest in construction, other than fitting out its own property, it is unlikely that the second condition will be met – although it is understood that some HMRC officers will waive this.
The tenant will be allowed to offset any CIS deductions from payments it receives against its PAYE liabilities to HMRC and so, for established businesses with significant numbers of employees the situation may be manageable. However, for small businesses looking forward to setting up in their new premises, the CIS can come as a nasty shock.
Think first – build later
As can be seen, this is a tricky area. Any landlord and tenant entering into a new lease where the landlord is looking to pay an inducement to the tenant, especially where building works are involved, should make sure that they take proper advice to avoid falling into some of the traps that may arise.
Leigh Sayliss, Partner at Howard Kennedy