Lee Sharpe looks at a common tax conundrum for landlords and advisers.
This article considers the fundamentals of how to approach the tax law governing repairs and improvements; when is something a repair or an improvement, or maybe both? I also briefly touch on the cash basis of assessment.
Why does it matter?
To summarise:
Repairs = ‘revenue expense’ – allowable against rental profits, saving income tax at 20%/40%/45%, depending on the income tax band applicable.
Improvements = ‘capital expense’ – allowable for capital gains tax (CGT) purposes on eventual disposal, saving CGT at 18%/28% (residential property) or 10%/20% (commercial property, or basically, anything that is not residential property).
Not only do repairs achieve a higher rate of tax relief, but you’ll probably get that tax relief sooner. Bearing in mind that it may be several years before a property is sold etc., the effect of general inflation means that getting relief for £10,000 today is also inherently more valuable than a deduction for £10,000 in (say) ten years’ time, such as if the expenditure is categorised as capital improvements and deducted much later when the property is sold.
Identify the asset being worked on
It is well established that an outright replacement of an asset will always be capital expenditure. If I use a laptop in my rental business and I replace it with a new laptop because the screen has broken, that cannot be a repair. It must be capital, as I have replaced the entire laptop (although I may be able to claim capital allowances, in the example of a laptop).
However, if I instead replace the screen alone, which is part of the laptop, that will be a repair to the laptop. I am replacing part of the asset, not the asset in its entirety.
Even so, if I replace a mediocre laptop screen with one of a substantively higher quality, this could be a capital improvement.
In terms of property:
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HMRC typically accepts that a house is the asset, so replacing kitchen units is replacing part of the asset (and may be a repair).
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But commercial property is different and may contain numerous individual assets, such as kitchen units, boiler, radiators, sinks, etc. In that case, each cupboard could be an asset in its own right (but unlike in ordinary residential lettings, it could be eligible for capital allowances).
Again, while replacing things like radiators, windows or kitchen units may seem relatively straightforward in standard residential lettings thanks to (1) above, note:
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While it does not matter how old or tired a kitchen is (I compare the new kitchen with the standard of kitchen fittings when they were originally installed), if I replace kitchen units of normal quality with ‘Ferrari’ kitchen units, that is an improvement, so it will be capital.
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If I add extra kitchen units (or radiators, or sinks, or similar), those additional units will comprise an improvement and capital expenditure.
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If it is a freestanding item and not fixed to the property, it will be an asset in its own right and will likely be capital even in a residential letting (e.g., furniture, television, fridge or microwave). However, it may be possible to claim ‘replacement of domestic items relief’ on such freestanding items when replacing on a like-for-like basis.
Identify what it is not
Sometimes it is easier to determine what something is not, rather than what something is. The logic here is that if the work done does not comprise an improvement or replacing the asset in its entirety, it should amount to a deductible repair (assuming it is accepted as a business expense in the first place, etc.).
Taking the above approach of identifying what is being worked on:
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In Hopegear Properties Ltd v Revenue and Customs [2013] UKFTT 331 (TC), the taxpayer repaired the main road to an industrial estate, including roadworks, relaying of some of the fibre-optic cable network, and work on the car park and footpaths. HMRC argued that the extent of the work comprised capital improvement. However, the First-tier Tribunal (FTT) held that each element essentially comprised work on part of a greater whole – nothing was being replaced outright.
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In G Pratt & Sons v Revenue and Customs [2011] UKFTT 416 (TC), the taxpayer resurfaced a road; HMRC argued that the concrete resurfacing was essentially a new and better road but failed to appreciate that a road is more than just the surface, and here it comprised stone ballast and hardcore base, etc. from when the road had originally been built. So, again, the taxpayer had not replaced the entire asset.
Is it an improvement on the original?
In Cairnsmill Caravan Park v Revenue and Customs [2013] UKFTT 164 (TC), the taxpayer replaced grass pitches for touring caravans with hardcore and gravel. HMRC argued that the work must comprise an improvement because the new surface was supposed to be longer-lasting. However, the FTT decided that the original grass pitches had lasted 50 years, so were already pretty durable; nor had the new pitches increased the value of the park. There was no substantive improvement.
In Steadfast Manufacturing & Storage v Revenue and Customs [2020] UKFTT 286 (TC), HMRC disliked that the taxpayer undertook a comprehensive resurfacing of its yard rather than continue to patch holes with gravel as it had done for many years. But again, the asset was simply being reinstated to its original condition. The size and load-bearing capacity were not improved over the original. Again, the taxpayer won.
What about improved materials or technologies?
Sometimes improvement is unavoidable. For example, if you try to replace an old single-glazed window, the window company will likely supply a double-glazed unit by default unless you specify otherwise (and likely pay more).
Perhaps the best-known case involving changing techniques and technologies is Conn v Robins Bros Ltd [1966] 43 TC266, where the taxpayer undertook a comprehensive refurbishment of a property that was, in places, up to 400 years old. Unsurprisingly, the work involved the use of more modern building techniques and materials (such as steel beams instead of timber). It was held that even so, the character of the property was essentially unchanged and the contested expenditure should be treated as repairs.
Can improvements 'taint' repairs?
HMRC will sometimes argue that repairs undertaken alongside improvements are just part of a greater scheme of capital improvements, and everything should be disallowed. This might be the case when replacing a dozen kitchen units with substantively higher-quality units; the improvement cannot be separated from the replacement – each item is better quality.
However, in the Conn v Robins Bros. case, the taxpayer had already agreed to disallow roughly a quarter of the total refurbishment costs as improvements; likewise, in Hopegear Properties, the taxpayer had already disallowed some specific alteration works as improvements. Apportionment is often perfectly acceptable.
The cash basis
Readers will be aware that since April 2017, unincorporated landlord businesses with annual gross income up to £150,000 will usually be brought within the cash basis of assessment unless they deliberately elect out and back to the more traditional accruals basis.
In theory, the cash basis looks only at cash income and cash outgoings without differentiating between capital and revenue expenditure. But in practice, the detailed legislation behind the regime is carefully devised to ensure that, in effect, most capital expenditure will still be disallowed all the same – such as on most alterations to land or buildings or on items for use in a normal residential letting, unless qualifying for replacement of domestic items relief.
Conclusion
There is a great deal of case law to assist landlords when claiming relief for expenditure on their properties. But not all cases favour the taxpayer. In Balnakeil v Revenue and Customs [2021] UKFTT 193 (TC), the case went against the taxpayer, even though one might at first see some similarities with Conn v Robins Bros Ltd, as above. Careful analysis is strongly recommended – and good record-keeping; the value of capital improvement costs that you incurred (say) fifteen years ago but have since forgotten about completely, is less like 28% and more like £nil.
