Business Related Expenditure: Much Ado About ‘Nothings’!

Alan Pink points out some situations where business related expenditure doesn’t get tax relief and looks at possible solutions to the problem.

There are two radically opposed ways of looking at the taxpayer’s right to deduct expenses in arriving at his taxable income, and it’s tempting to say ‘never the twain shall meet’. 

To taxpayers themselves, and to tax professionals such as accountants and lawyers, the approach taken by HMRC and the government seems, quite frankly, bonkers. Their view seems to be that allowing relief for expenses laid out is a generous dispensation by the government under which the public purse is subsidising the individuals concerned. This approach seems to underlie George Osborne’s introduction of the notorious ‘Osborne tax’ a couple of years ago, under which interest on buy-to-let mortgages is being restricted; more on that below. But the taxpayer, by contrast, and those acting for him, see merely examples of HMRC taking tax on a higher level of income than they have actually received, because of the dis-allowability of certain types of business related expenditure. 

But, let’s get down to brass tacks and give a few examples of what I mean. 

In my view, this fairly archaic concept is long overdue for an overhaul, but the rule is still very firmly with us as things stand. If you incur any long-term expenditure, which is going to benefit your business for more than one year, this expenditure is labelled ‘capital’ and has to be disallowed in computing the amount of income on which you pay tax. 

One of the most obvious examples of capital expenditure is improvements to a property. Whether you’re a landlord letting out that property, or a trading business which is using the property for the purposes of the trade, the improvement expenditure is going to be categorised as a ‘capital’ item and will be quite simply disallowed completely in calculating the tax you have to pay. So, you can end up, in an extreme case, with no money left at the end of the year, but a whacking great tax bill on your book ‘profit’. 

Other examples of capital expenditure are legal and other fees in connection with the purchase of fixed assets, like properties; and fees relating to changing the capital structure of the business; for example, merging or demerging groups, and issuing new share capital. 

This may all seem very unfair to you; and I must admit, it does to me as well. But, there’s no point repining if we are in business and in the UK. The fundamental rights and wrongs of the tax system as it applies to businesses are not something on which enough votes hang for anything to be done about it in the foreseeable future. Short of lobbying one’s MP to get the rules changed, though, what can be done? 

There’s a specific issue arising where the capital expenditure concerned is the purchase of a building, and I’ll come on to that next. But, in more general terms, the point to note is that capital expenditure very often doesn’t go unrelieved against tax in the long run. Let’s take the examples of legal fees connected with purchasing a property, and builders’ costs for improving a property. 

Both of these are, in fact, allowable expenses in the long run; but not against income tax. Instead, if they are properly noted down and recorded on a long-term basis, they are deductible in calculating the capital gains tax (CGT) that is payable on an ultimate sale of the property. 

This is where a lot of businesses fall down in their record keeping. I wish I had a fiver for every time a client or prospective client has come to me asking me to calculate, and if possible mitigate, their liability to CGT on the disposal of an asset, and when I ask whether they have laid out any capital expenditure on acquiring or improving the asset the answer is ‘yes’ – however, the immediate follow-on question, which is ‘how much’, is answered in the vaguest possible manner. 

‘Oh, I spent about £40,000 on extending that property, about ten years ago.’ Can the taxpayer concerned provide evidence of this expenditure? All too often, the answer is ‘no’. 

So, the first lesson is to note down religiously all expenditure that you can’t claim against income because it is capital in nature. 

Except for those buying properties to develop and sell, property purchases generally fall into the ‘capital’ category that I’ve just been talking about; and so, the outlay is non-tax deductible. Until not so long ago, the tax system recognised this, and had limited sorts of tax relief for certain types of buildings. These reliefs were industrial buildings allowance and agricultural buildings allowance. Those allowances were abolished some years ago now, with surprisingly little protest from the taxpaying public. So, any kind of commercial building, or indeed residential building, is now a tax ‘nothing’. 

But, there is an important exception to this rule where you are talking about commercial properties and furnished holiday lettings (FHL), as I’ve said. This exception consists in the ability to allocate some of your purchase costs to claimable fixtures and fittings. Fixtures and fittings in commercial and FHL properties are treated as ‘plant and machinery’ and are eligible for a special type of tax depreciation referred to as capital allowances. It’s true that these don’t give you tax relief very quickly; the rates are 18% or 8% of the expenditure per annum, depending on the precise type of fixtures and fittings you’re talking about. But, there is an important practical issue here which needs highlighting, and where there have been some comparatively recent changes to the legislation. 

The effect of these changes is that it is now absolutely essential to consider, and determine, the value of the claimable fixtures element before you complete the purchase. The new rules require the vendor of the property to have pooled the expenditure – that is, put it in their own claimable computation, and there is also the requirement to agree the attributable value between the vendor and the purchaser at the time of the purchase. There’s no room here to go into all the detail of these new, much more restrictive, requirements; but, suffice it to say that the matter needs to be thrashed out thoroughly between the purchaser’s solicitors and those acting for the vendor. The person who loses out in the event that the capital allowances situation isn’t properly ‘nailed’ is the purchaser, because HMRC will refuse a deduction unless their red tape has all been thoroughly observed.

This is a particularly aggravated case of inequity in taxation. Business entertaining generally is quite simply disallowable for tax purposes, and it doesn’t matter at all to HMRC how essential to the conduct of the business, or how customary, the entertaining is. So, it’s a good example of businesses having to pay tax on a higher profit than they’ve actually made. To add insult to injury, the disallowance applies not just in relation to the direct taxation on the profits of the business but it also applies for VAT purposes (unless the entertainer is a pub, restaurant, or similar). 

There is just one chink of light in the rules. This applies in the situation where you are running a trading company and you entertain clients or customers in the course of that business. Even if the people you are entertaining also happen to be friends, provided the basic framework of the entertaining is business-related, there is a benefit to you in that your share of the bill for that posh lunch or dinner is paid for by your company but isn’t taxed on you, at least in practice, as a benefit-in-kind. It’s true that you can’t claim a deduction for this type of expenditure when doing the company’s corporation tax; but you could end up eating and drinking very expensively, on your company, with no practical income tax implications. 

This is the newest, and in my view most infamous, example of a tax ‘nothing’. As I’ve already commented, the Chancellor, when introducing this phased disallowance of interest on buy-to-let mortgages, talked as though the government had been excessively generous to landlords in the past by giving them tax relief for interest, when individual homeowners (no doubt most of them ‘hard-working families’) didn’t get any relief. 

He blithely ignored the fact that homeowners don’t have a corresponding income against which the interest could be offset in any event. When there was mortgage interest relief, going back many years now, the original reason for introducing that was because individuals were charged to tax as if they were receiving rent from living in their own homes (another crazy tax inversion). It took some time after the abolition of this rule for the government to twig to the fact that they shouldn’t be allowing loan interest relief anymore. But none of this has any relevance to the principle that buy-to-let landlords should only be paying tax, in my view, on the actual profit they’re making. 

The way the disallowance works is that, ultimately, the interest paid won’t be allowable for higher rate income tax purposes. The remedy, or remedies, have been extensively discussed, as this is a very big issue for quite a lot of people. Indeed, there are people who will be paying more tax than their actual net income, giving a quite amazing modern example of a more than 100% tax rate. 

The main remedy that is being scouted about is putting properties into limited companies because limited companies don’t suffer the Osborne tax. The problem with this is the possible incidence of CGT and stamp duty land tax on putting the properties into the company. Alternatively, some people advocate limited liability partnerships (LLPs) with company members, in which a proportion (perhaps a high proportion) of the net rents received by the LLP are attributed to the company ‘partner’. 

More simply and straightforwardly, sharing the ownership of the property amongst family members who are lower rate income taxpayers could solve the bulk of the problem in some cases. In some cases, it may even be feasible to repay the loans and hence sidestep the problem altogether.