If rent were a finance cost, we wouldn’t call it rent…

6 Feb 2018

Policy area: Tax & Finance

BPF's Director of Policy (Finance) Ion Fletcher shares his views on the latest HMRC consultation on accounting changes for leasing. 

A potentially unhappy coincidence of tax and accounting changes is in the offing and while we’re (sadly) increasingly used to the tax system throwing out counterintuitive results, this one is particularly baffling.

If you’re an avid BPF follower, you’ll know that the government recently introduced rules restricting the amount of corporation tax relief available on debt interest for businesses that pay more than £2m in interest per year. To effectively tackle the avoidance government was worried about, the definition of debt interest is very broad and includes 'interest' charges under certain leasing arrangements.

Completely separately, the International Accounting Standards Board (IASB) recently approved a new accounting standard for leases (IFRS16). Under this new standard, which comes into effect in January 2019, all leases will need to be shown on a company's balance sheet and associated 'interest' and 'amortisation' charges recognised in the P&L account. This does away with the historic distinction between ‘finance’ and ‘operating’ leases.

The potential upshot of this is that lease payments such as rent paid by occupiers - which are in no way interest costs - end up being treated as interest for tax purposes and companies lose corporation tax relief on them. Yes, you read that right – if you occupy property not only do you have to pay uncompetitively high levels of business rates, you might not even get tax relief for the full cost of your rent!

Medium and large businesses that use a lot of property (e.g. retail, health care, leisure) are likely to be most affected.

This is a bonkers outcome – businesses do not lease property to avoid tax, they do it because they need somewhere to live. Treating an element of rental costs as if it were interest just doesn’t make sense; we call it rent for a reason – because it isn’t anything else! It would also be double taxation – occupiers denied tax relief on their rent costs, but landlords taxed on that rental income.

Fortunately, the government recognises that there is an issue here and is consulting on options to address it. However, none of the three options are particularly palatable.

Option 1 is for the tax treatment of a property lease to follow the accounting treatment. Doing this leads us to the silly outcome outlined above. I’m surprised the government is actually contemplating this.

Option 2 is slightly better, in that occupiers continue to get tax relief for their lease rental costs if their landlord accounts for the corresponding lease rental income as ‘operating’ income rather than ‘financing’ income. This should generally be the case with property leases, but this option means occupiers need to ask their landlords how they account for property income in order to get tax relief. This should not be necessary.

Option 3 is to ignore how a lease is accounted for and create new tax tests to determine whether full relief is available. Here the government is proposing three tests:

  • Does the lease transfer the ‘risks and rewards’ of owning the asset to the occupier?
  • Is the present value of lease payments worth >80% of the asset’s fair value?
  • Is the lease term >65% of the asset’s useful economic life?

If the answer to just one of them is ‘yes’, then full tax relief for rent may be denied to the occupier. Now, it might be that most real estate won’t meet any of the tests and that on the whole property occupiers continue to get full tax relief. But new tests introduce new complexity. What exactly are the ‘risks and rewards’? How do you define the ‘useful economic life’ of a building? Why does it matter that the value of lease payments is more than 80% of an asset’s fair value?

Ultimately, the rules should recognise that the cost of renting a property is a legitimate business expense that deserves tax relief. If you agree, please make sure you respond to the consultation to say so.