Author: Madeleine Holding
Madeleine Holding, Associate, Fladgate LLP (firstname.lastname@example.org)
Capital contributions can be a useful inducement to tenants but proper consideration of their impact is often missed in negotiations. It is important to identify the correct reason for the payment as this can affect the VAT treatment, whether the construction industry scheme (CIS) applies, whether capital allowances are applicable and the treatment of any works on rent review. Incorrect treatment of capital contributions can lead to fines, tax liabilities and, if such treatment is not correctly documented, later disputes with tenants.
A capital contribution is a payment by a landlord to a tenant in respect of works to premises. Generally, they are made on the grant of the lease but they could be made when works are required to the premises or on assignment of the lease. Capital contributions are more commonly seen in the retail industry (for shopping centre leases) but can also be made in respect of office lets.
The most common reasons for payments by a landlord to a tenant on the grant of a lease are:
Pure inducement payments and contributions towards the tenant’s fitting-out works do not involve the tenant providing a service to the landlord and, therefore, generally fall outside the scope of VAT. On the other hand, a capital contribution towards the cost of works which would usually fall to be carried out by the landlord is treated as a payment in return for the tenant providing services for the benefit of the landlord. VAT would therefore be payable at the standard-rate. What works “would usually fall to be carried out by the landlord” is a question of fact and a commercial matter. If the works are required in order to get the tenant to take the lease, then this cost commercially falls to the landlord even if such repairs would fall within the tenant’s repairing covenant. It should be made clear at the outset whether the amount the landlord agrees to pay is inclusive or exclusive of VAT.
The CIS is a tax deduction scheme. The person making payments for works (the contractor) must deduct the tax from the payment to the person carrying out the works (the sub-contractor) and pay it direct to HMRC. “Contractor” and “sub-contractor” have a much wider meaning under the CIS than is understood in the construction industry and can catch payments by a landlord to a tenant even if the tenant is not a builder and is not carrying out the works itself.
Pure inducement payments and contributions towards the tenant’s fitting-out works fall outside of the CIS and the landlord must therefore pay the gross amount to the tenant. If a payment is made for other works, the tenant must be paid net of tax. There are exceptions, however, and the landlord must establish whether these apply before the payment is made; the payer will only fall within the CIS if its average spend on construction is more than one million pounds per year and, if the payee has registered with HMRC under the CIS, it must be paid gross.
Capital allowances legislation deems fixtures to be owned by the person incurring the expenditure rather than the person immediately using it. Therefore, if the landlord can claim capital allowances and pays for any plant and machinery, capital allowances on those items will be available and this should be documented between the parties. If the contribution does not cover the whole cost of the plant and machinery, then the tenant will argue that the landlord is entitled to part of the allowances only. This is a commercial matter for the landlord and the tenant and should be clearly documented.
Under standard rent review clauses, only works carried out at the tenant’s own cost are disregarded. Therefore works paid for by the landlord will be rentalised and the tenant will pay a higher rent. If the contribution only relates to part of the tenant’s works, it must be made clear which part(s) of the works are to be rentalised and which are to be disregarded.
Careful consideration should be given to capital contributions to ensure that both parties are clear on the purpose of the payment and, therefore, how such payment is to be treated for tax and rent review purposes. Landlords should seek advice from their accountants and legal advisers and ensure that the position is agreed between the parties in advance to avoid later delays. Fladgate has experience in acting for Landlords in relation to capital contributions at all stages of a lease and would be happy to advise on their treatment.