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INDEX Taxation of Lessors Rate of taxation The UK corporation tax rate is currently 30 percent. Corporation tax is payable in quarterly instalments, although these rules are modified for smaller companies. Interest is charged on underpayment of the final tax liability and, although overpayments will generally earn interest, it is at a lower rate. Incorrect, incomplete or delayed returns are subject to penalties. UK leasing groups need to monitor carefully the group’s actual and projected tax position to avoid interest or penalties and to ensure that they price business appropriately. There are no local or state corporate income taxes in the UK.
Individuals Equipment leasing by individuals is not generally tax efficient, since an individual is prevented from setting capital allowances (tax depreciation) on equipment for lease against his general income except where certain very restrictive conditions are met, including the requirement that the individual devotes substantially the whole of his time to carrying on a leasing trade. Individuals’ leasing activities are now confined almost exclusively to the letting of real property qualifying for tax allowances.
Corporates Corporate Taxation reform The UK Inland Revenue released in August 2003 a consultative document on Corporation Tax Reform proposing a number of wholesale reforms affecting the taxation of leasing activity. These are the subject of ongoing discussions with the leasing industry, but the initial proposals are that the entitlement to capital allowances in respect of leased assets under finance leases passes from the lessor (the legal owner) to the lessee (beneficial owner). In addition, the current prohibitive overseas leasing rules may be repealed, dealing with the belief that the current rules breach EU Treaty principles. The proposals, if eneacted, will have a fundamental impact on the economics of finance leasing business in the UK. At this moment in time, the leasing industry is lobbying to attempt to restrict the extent of the changes, and so it is difficult to say what changes will be implemented. The analysis below is a summary of the current position, but it must be borne in mind that the UK rules may change fundamentally following implementation of the proposed reforms General corporates For UK tax purposes, a finance or operating lease is generally treated as a rental agreement. On this basis, lessors of assets under both finance or operating leases would normally be taxed on their lease rentals earned in an accounting period. Operating leases - income recognition For operating leases, the tax recognition of income will normally directly follow that adopted for accounts purposes. Finance leases - income recognition For finance leases, rentals as such are not reflected in the profit and loss account. The common practice is to accrue each rental over the period to which it relates. This has generally been taken to be the period to which the rents are expressed to related contractually, or are commercially attributable. In the past some lessors recognised rents when due, although this basis is no longer accepted for new lessors. In respect of finance leases entered into after 26 November 1996 (and for certain existing leases - see termination arrangements below) new rules require that lessors are taxable on the higher of the normal rents (ie as determined following the practices outlined above) and the accountancy rental earnings (“ARE”), the amount treated in accordance with normal UK accounting practice as the gross return on the lessor’s investment. Where the excess of ARE over normal rents (commonly known as “negative depreciation”) is taxed under this rule, the excess may subsequently be recovered in later periods pound for pound against an excess of normal rents over ARE. The effect is to introduce a minimum rental income recognition equal to the finance income. Under the current rules:
Operating and finance leases - expenses Lessors are able to deduct all expenditure normally deductible for UK tax purposes (including financing costs, maintenance costs and administrative expenses) although they will not be able to take a deduction for depreciation of the leased asset as charged in the accounts. Instead, they will be able to claim tax depreciation in the form of capital allowances (see below). Hire purchase contracts For UK tax purposes, a different treatment applies for a hire purchase or conditional sale contract (even though such contracts are accounted for as finance leases). The lessee/conditional purchaser under such a contract is treated as the owner for tax depreciation purposes from the outset. For this treatment to apply:
In the remainder of this chapter reference to hire purchase contracts should be taken to include conditional sale, and reference to a finance lease should be taken to exclude hire purchase and conditional sale. A hire purchase contract is treated for tax purposes as the sale of the asset on deferred terms. Therefore, a hire purchase vendor will be taxed on its net finance margin under the contract after deducting administrative and other expenses normally deductible for UK tax purposes. Eligibility of lessors for depreciation allowances In the UK, tax depreciation allowances are given in the form of capital allowances. These are worked out in accordance with detailed statutory rules. Subject to these, the UK tax law generally permits a lessor - as legal owner (rather than a lessee) - to claim capital allowances under finance or operating lease arrangements. Under a hire purchase contract, however, the purchaser (lessee), and not the seller (lessor), will normally be entitled to capital allowances. Individuals In principle, an individual who incurs lease rentals wholly and exclusively for the purposes of a trade will be entitled to the same treatment of rentals and the same depreciation allowances as a corporate trader - see below. For income tax purposes, rental expenses would need to be recognised in accordance with SSAP 21. Corporates Lease rentals which are incurred wholly and exclusively for the purposes of a trade carried on by the lessee are, in general, allowable trading deductions. If the contract is classified for tax purposes as a hire purchase contract rather than a lease (see above) then the lessee will only obtain a deduction for the finance element of payments made under the contract. Capital allowances will be available in respect of the capital element. Operating lease rentals are deductible in accordance with their treatment in the accounts. For finance leases, the lessee’s accounts will not reflect a rental expense. However, under Inland Revenue Statement of Practice 3/91 the lessee is allowed to deduct in each period an amount of rent equal to the sum of the finance element of the rent and the depreciation on the capitalised asset as shown in its accounts under SSAP 21. However, the Inland Revenue will wish to ensure that the depreciation policy adopted is reasonable in the light of the expected commercial economic life of the asset. Thus relief is given to the lessee for the aggregate rentals paid net of rebates, but the timing of these deductions will be effectively determined by the accounts treatment of finance lease costs. There are specific restrictions on deductibility where the rentals are paid in respect of a car originally costing more than GB£12,000 or in some cases where an asset has been sold and leased back. As discussed above, a lessee will not normally be entitled to depreciation allowances where the contract is a finance lease or an operating lease. However, under a hire purchase contract, it is generally the purchaser (‘lessee’) who is entitled to claim capital allowances. If the purchase option is at a nominal price, or for a conditional sale, allowances will be given from the outset on the cash price. If the option price is not nominal but it is below anticipated market value at the date of the option, allowances on the option price will arguably be deferred until exercise of the option. (For a credit sale, where title passes to the purchaser at the outset, then subsequent instalments only become eligible for allowances to the purchaser when incurred). General As discussed above, UK tax depreciation is given in the form of statutory capital allowances. For a UK lessor to be entitled to claim allowances, the leased asset must belong (or be deemed to belong) to him. The rationale is to prevent an element of subjectivity in setting accounting depreciation rates. For a trading lessor, capital allowances are first given in the period in which the expenditure on the asset is incurred, whether or not it has yet been brought into use in the leasing trade. For a purchaser under a hire purchase contract, allowances are normally first given in the period in which the asset is brought into use by the purchaser. Capital allowances may be disclaimed, in whole or in part, by giving notice to the Inland Revenue within the appropriate time limit (see further below). You should note that the capital allowances legislation was recently re-written into the Capital Allowances Act 2001 with the intention of simplifying the legislation. Whilst the re-write is not intended to modify or amend the operation of the rules in any substantial way there are some minor changes (which may be either inadvertent or intentional) which impact new or existing leasing arrangements. Eligible assets The types of asset in respect of expenditure on which capital allowances are available are set out in statute.. The more common types of asset for which allowances are available include:
Legislation gives some guidance as to what is and what is not plant. However, it is still not possible to produce a categorical list and specialist advice should be sought to ascertain the status of any particular item. The remainder of this chapter deals only with the rules for allowances on plant and machinery (‘equipment’). The basic code for plant and machinery includes modifications for certain classes of asset, which include:
Rates of allowance Expenditure incurred on the construction of industrial buildings and agricultural buildings will - under certain conditions - qualify for Industrial Buildings Allowances and Agricultural Buildings Allowances. These allowances are given at a rate of 4 percent per annum on a straight-line basis. Allowances for expenditure on plant or machinery are given at a rate of 25 percent per annum, on a reducing balance basis, unless the plant or machinery is a “long-life asset” (see below), when the rate is only 6 percent. For expenditure on plant or machinery incurred by small and medium-sized businesses a first year allowance of 40 percent is available. First-year allowances of 100 percent are available in certain circumstances, including:
Allowances are given at 10 percent, where they are available at all, in respect of assets leased to non-UK residents who do not use the asset in a UK trade.
Long-life assets A long-life asset is one with an expected working life, when new, of 25 years or more. Typically, long life assets will include substantial plant and machinery such as utility installations and major industrial plant. Specifically excluded are cars and equipment installed in offices, hotels, retail shops, showrooms and dwellings. The Inland Revenue has agreed special arrangements for certain commercial passenger aircraft with the British Air Transport Association whereby, broadly, 50 percent of the expenditure on an aeroplane is treated as qualifying for allowances at 25 percent per annum, and 50 percent is treated as qualifying for allowances at 6 percent per annum. Each airline or lessor company must elect for this treatment. The position will be reviewed after 31 December 2003. The long-life assets rules generally apply to expenditure contracted for after 26 November 1996 but the 25 percent rate will continue to apply to sea-going ships and railway assets bought before 2011 for use in providing a railway service to the public in the UK or the Channel Tunnel. Thereafter the 6 percent rate will apply. The 25 percent rate also continues to apply to expenditure incurred before 2001 where it was contracted for before 26 November 1996 and to expenditure on second-hand equipment if the vendor had been entitled to the 25 percent rate when he acquired the equipment. Notification and claims Broadly, for chargeable periods ending after 5 April 1998 for income tax and 31 March 1998 for corporation tax, taxpayers are no longer required to notify the UK tax authorities of expenditure on which capital allowances will be claimed. Previously there was a requirement to give notification within two years of the end of the accounting period in which the expenditure was incurred. A failure to do so would not result in loss of the allowance but they would not be available for accounting periods preceding the period in which notification was given. However, capital allowances must be claimed in order to obtain a tax deduction. The claim is made on the tax return. The taxpayer may claim allowances up to the full (normally 25 percent) entitlement for the accounting period. Claiming less than the full entitlement defers the allowable expenditure to future periods where allowances on it can, in certain circumstances, be used more advantageously. Allowances are restricted on a time apportionment basis in a short accounting period, or during a period in which a new leasing trade is started. In practice the claim requirement (and the additional notification requirement which previously existed) is met by the inclusion of the capital allowances in the taxpayer’s return. Taxpayers may also withdraw a claim for allowances. The time limit to withdraw such a claim is two years after the end of the accounting period for which the claim was originally made. For ships, there is a more advantageous form of disclaimer known as ‘free depreciation’, whereby allowances not taken may be claimed in a later period, rather than falling back into the pool (see below) to be relieved at 25 percent per annum. In addition, in certain circumstances balancing charges on ships may be rolled over into future expenditure on ships within the same group within the following six years. The rules for the offset of excess capital allowances, whether by group relief or against other income of the same company, are complex and can depend upon whether the lessee or lessor is trading. This is a complex area and specific advice should be sought. Manner of giving allowances For lessors, the calculation of capital allowances depends upon:
Pooling Generally all expenditure qualifying for capital allowances incurred by the same person in respect of the same trade (“qualifying activity”) is ‘pooled’. This means that all such expenditure is accumulated into a single amount in respect of which capital allowances are calculated. When an acquisition takes place, the purchase price of the asset is added to the balance of the pool. Conversely, when a disposal takes place, the disposal proceeds (limited to cost) are subtracted from the balance of the pool (although, in certain instances, the disposal value may be taken to the market value of the asset at the time of disposal). Capital allowances are given at the appropriate rate on the balance of the pool at the end of each accounting period after accounting for all acquisitions and disposals in that accounting period. Expenditure on certain items is dealt with outside the main pool, either in class pools (containing expenditure on all assets of a certain type) or in single asset pools. Such items include:
Where the proceeds of sale (or, in certain cases, market value) of assets disposed of during an accounting period exceed the balance of unrelieved expenditure in the pool, the difference is treated as an amount of taxable income known as a ‘balancing charge’. Where a pool ceases, a balancing allowance will be made if the proceeds of the sale (or, in certain cases, market value) are less than the balance of unrelieved expenditure. A pool for an individual asset will generally cease with the disposal of that asset, but the general pool will normally only cease if the trade itself ceases. An example of a pooling calculation is given below:
Short-life assets The UK tax law recognises that, for short-life assets, the pooling method outlined above may spread tax depreciation over a far longer period than the commercial life of the asset. Accordingly, a taxpayer can elect for assets to be ‘depooled’ - ie taken out of the main pool - provided that this election is made within two years of the end of the accounting period of the expenditure for companies and the first anniversary of the 31st January following the end of the tax year of expenditure for other taxpayers
Each depooled asset is assigned to its own individual pool. The potential advantage of this treatment is that, in certain circumstances, a balancing allowance may be made on the disposal of the asset without the trade having to be discontinued. If the disposal proceeds are less than the pool balance (as may often be the case with, for example, computer equipment which generally depreciates rapidly), then a balancing allowance will arise. Conversely, if the disposal proceeds are greater than the balance in the pool, then a balancing charge will arise which will be taxable in full in the year of disposal. Accordingly, the decision as to whether to make a short-life asset election is not straightforward and must be considered carefully for each asset to prevent the likelihood of accelerating taxable income. If an asset in respect of which a depooling election has been made is not disposed of within four years from the end of the accounting period in which it is acquired, the unrelieved balance of expenditure on the asset is transferred to the general pool and no balancing charge or allowance arises. Depooling elections are not available for certain assets, including ships, cars and most assets leased to non-UK residents or to non-traders. Special restrictions for finance lessors With effect from 2 July 1997, where the expenditure concerned is incurred on equipment that is the subject of a finance (but not operating) lease, the amount to be included in the pool in the year of acquisition is restricted by reference to the length of the lessor’s accounting period then outstanding. For instance, if the expenditure is incurred three quarters of the way through the accounting period the proportion of the expenditure eligible for inclusion in the pool is restricted to one quarter with the balance being included in the following year. Where the lessor finances a purchase of equipment subject to a finance lease by means of a hire purchase contract this rule is varied so that the amount to which the proportional restriction is applied is limited to the capital element included in each hire purchase instalment paid by the lessor. A shipping company may, providing an election is made, fall under the UK tonnage tax regime for the purposes of calculating its profits chargeable to corporation tax. Broadly, a notional profit is calculated in respect of each ship depending on its tonnage. Accordingly, where a lessee company is taxed under this regime, there are restrictions on the capital allowances which finance lessors may claim. Generally, for defeased leasing and sale and leaseback arrangements the lessor is not entitled to any capital allowances. For finance leases to tonnage tax companies capital allowances are generally restricted so that up to GB£40m of qualifying expenditure is eligible for 25 percent allowances, GB£40 to GB£80m is eligible for only 10 percent allowance, and any expenditure in excess of GB£80m is not permitted any capital allowances at all. Fixtures Special considerations apply where the leased equipment is to be affixed to land or buildings. Under English law, such equipment becomes part of the property to which it is affixed and so belongs to the freeholder of the property. Where a person leases from an equipment lessor equipment which is to be affixed to land, there is specific legislation which permits the lessor and the lessee to make a joint election so that the equipment is treated as belonging to the equipment lessor for capital allowances purposes, subject to certain conditions. The most important of these conditions is that, in most circumstances, the equipment lessee should use the equipment for the purposes of a qualifying activity (Thus, for example, allowances can be denied if the equipment lessee is a local authority). Similarly, if a tenant of leased premises installs equipment in those premises, he is deemed to own the equipment for capital allowances purposes provided he has incurred expenditure on it. Because a fixture is legally part of the land to which it is fixed, rental income from a leased fixture is taxable on the lessor under somewhat different rules from those which apply for normal trading income. Consequently, depending on the precise legal terms of the arrangement, the lessee may be required to withhold income tax on the rentals if the lessor is non-UK resident, and there may also be an impact on the manner in which excess capital allowances can be relieved. Specific advice should always be sought. Computer software There is specific legislation under which a trader incurring expenditure on a right to use or otherwise deal with computer software can claim capital allowances in respect of that expenditure. The precise scope of this relief remains uncertain, and sometimes commercial requirements in computer leasing may still cause difficulties. Capital allowances - areas of difficulty There are - in practice - a number of areas in which eligibility for capital allowances is difficult to determine. This makes it advisable that lessors obtain specialist advice before undertaking major transactions. Investment or other tax allowances There are no other UK tax allowances which are relevant to leasing. Tax consequences of different methods of financing General The lessor’s interest deduction may be treated either as a trade expense in arriving at the profits of the trade or as a non-trading debit. Depending on the treatment which applies, there may be different tax consequences. Specific advice should be sought as to the most suitable form of financing for a leasing activity. The legislation includes a wide ranging provision to deny relief for interest where, broadly, avoidance of tax is one of the main purposes underlying the borrowing. Although the provision is not used in a general attack on finance leasing, its application must nonetheless be considered carefully. Again specialist advice is required. The lessor must incur capital expenditure on the leased asset In order for a lessor (or other trader) to qualify for UK capital allowances, the lessor must incur capital expenditure on the provision of the leased asset. Case law confirms that expenditure financed by non-recourse borrowings may not be regarded as incurred by the lessor. Likewise, a recent case has held that the lessor whose rental receipts are fully secured by a defeasance deposit may also not be regarded as satisfying the requirement – although this case is understood to be under appeal. Non-recourse financing - potentially - has other difficulties apart from capital allowances, and any financing structure with such characteristics requires specific advice. It is also doubtful whether a purchaser under a hire purchase contract has incurred capital expenditure on an asset if the purchase option is exercisable at a price approximating to anticipated market value. Any such option needs careful review to identify which party is entitled to allowances - indeed it has sometimes been suggested that neither party may be entitled to allowances. Foreign exchange considerations The UK has detailed rules for the tax treatment of exchange gains and losses of financial instruments to eliminate interest and currency risk, and of debt instruments. The broad objective of the rules is to ensure that the tax consequences of these items are generally in line with their accounting treatments provided these are in accordance with normal UK accountancy practice. At the time of writing, there are proposals for the introduction of a new foreign exchange gains and losses regime for tax purposes (see end of this chapter). Accordingly, you should obtain current specialist advice in respect of foreign exchange related leasing transactions. The rules may produce anomalies in certain cases, but the fact that companies are now allowed under certain circumstances to compute capital allowances in non-sterling currencies has reduced these. This is a complex area and specialist advice should be sought. Transfer of ownership of asset or of rentals Transfer of leased assets The transfer of a leased asset during the lease period will usually be treated as a disposal for capital allowances purposes. This may result in a balancing charge (effectively a clawback of allowances which is taxed immediately) or merely in a reduction in the balance of the pool (effectively a reduction of future writing-down allowances). The principal exception is where the asset is transferred as part of the transfer of a trade to a ‘successor’ company within - broadly - 75 percent common ownership, in which case the transferee takes over the transferor’s pool value and no balancing charges or allowances arise. On a transfer of existing leased assets, it will be necessary to show that the lessor’s capital expenditure relates to the assets acquired. There are special rules relating to sale and leasebacks - see below. The transfer of rentals due under leasing contracts without the underlying assets may involve a number of UK tax problems. If the purchaser is not a financial trader the rent receivables will not be treated as income under a debt instrument. Because of these difficulties, where an eventual disposal is contemplated it may be easier for the leasing to be carried out by a separate company which can be sold as a separate entity. If the leasing is a trade and is carried on by a company which also carries on other activities, the trade can be transferred to a subsidiary which becomes a successor company; a disposal of the successor company can then ensue. The corporation tax and VAT treatments for the transfer of a lease portfolio - however structured - are complex and subject to a number of anti-avoidance provisions. Specific advice should therefore always be obtained. Capital gains The treatment of a disposal of leased assets for capital allowances purposes, including the circumstances in which a balancing charge or allowance may arise, is dealt with above. The treatment of disposals for the purpose of corporation tax on capital gains (or capital gains tax for individuals) is quite separate. Generally, a chargeable capital gain will arise only if disposal proceeds (or deemed disposal proceeds) exceed original cost (rather than tax written-down value) plus indexation allowance (an allowance for inflation over the period of ownership). Such circumstances are - of course - unusual for plant and machinery. Special rules apply in the case of assets acquired before 31 March 1982. Indexation allowance remains for corporates, but has been withdrawn for individuals, and has been replaced by a new “taper relief” with effect from April 1998. On a disposal of machinery or plant which has qualified for capital allowances, an allowable capital loss is not available to the extent that capital allowances were available. If the machinery or plant disposed of is tangible, movable property and has never qualified for capital allowances - because, for example, it has been leased to non-residents - then no chargeable gain or allowable loss can arise on the disposal. Disposals of individual items of plant or machinery where the disposal proceeds are less than GB£6,000 are exempt from tax on capital gains in any case. Sale and leaseback There are anti-avoidance rules which may restrict the lessor’s writing-down allowances where a leased asset is acquired in a sale and leaseback transaction or from a connected person. The rules defining a sale and leaseback are broad, and can catch financings of equipment which a user is contracted to acquire, but which has not yet been delivered or paid for. Similarly there may be implications for the lessee under a sale and leaseback arrangement, including possible restriction on the deductibility of rentals.
Capital allowances are further restricted if the equipment is the subject of a sale and finance leaseback. In this case, the amount to be included in the lessor’s pool of expenditure is restricted to at most the notional tax written down value of the asset calculated on the basis that the original cost of the asset has been reduced at the appropriate rate of writing down allowances (ie at 25 percent or 6 percent) for the period of the lessee’s ownership prior its sale to the lessor. The finance lessor’s entitlement to writing down allowances is denied altogether if, broadly, there are provisions to remove ‘the whole, or the greater part, of any non-compliance risk’ which would fall on the lessor. The non-compliance risk is that payments under the lease are not made in accordance with its terms. The full scope and effect of these provisions is not clear and specialist advice is required. Back and front loaded leases There are special rules regarding the timing of the taxation of income for finance lessors. See ‘Taxation of lessor’ above. Leasing and leveraged tax aspects From the foregoing paragraphs it will be apparent that leasing can give rise to tax benefits, which will normally be passed to the user, whose cost of investment in new equipment is thereby reduced. However, there are restrictions on the set-off of capital allowances for leased equipment particularly if leased otherwise than in the course of a leasing trade. Specific advice should be sought. Some important tax planning considerations are as follows:
Limited partnerships are sometimes suggested as vehicles for leasing ventures. The profits of a limited partnership, whether distributed or not, are taxed as part of the income of each partner; the limited partnership itself is not a taxable entity. Limited partners are unable to relieve against their general income partnership losses which exceed their investment in the partnership (capital invested plus undrawn profits). For the implications of non-recourse finance, see above. Termination arrangements Finance leases Under a finance lease the rentals paid by the lessee will have - by the end of the primary lease term - amortised substantially all the lessor’s investment in the lease. Therefore the lessee will wish to enjoy the benefit of the residual value of the asset. This cannot be achieved by a bargain purchase option since the contract would become a hire purchase arrangement. Instead it may be achieved in three ways:
Special rules apply to a finance lease that includes both negative depreciation (see taxation of rentals for lessors above) and a possibility that the lessor could receive part of the income from a lease in a form (“a major lump sum”) that is not taxable as rental income. Broadly, the special rules tax the accruing lump sum as it arises in the form of negative depreciation. In addition, any major lump sum is treated in full as disposal proceeds for the purposes of capital allowances, and thus tax depreciation given in earlier periods is recaptured. Where the conditions are met, the rules apply to a major lump sum received after 26 November 1996 irrespective of whether the lease was entered into before or after then; care is required to ensure that changes made to an existing lease do not bring the lease within the special rules. The rules are complicated and specialist advice is required. Operating leases Under an operating lease, a lessee will generally have no right to share in the disposal proceeds of the asset. Accordingly, the lessor will simply adjust his capital allowances pool to reflect the actual disposal proceeds received. Hire purchase Under a hire purchase contract, a purchaser will normally fulfil the terms of the contract by making all the payments due and exercising the purchase option by the payment of the option price. This price will be taxable in the hands of the seller.
International issues Taxation of non-resident lessor/resident lessee The concept of a permanent establishment is relevant to UK tax law mainly in the context of tax treaties. Whether leasing equipment gives rise to a permanent establishment, and hence to a liability on the lessor for UK corporation tax, will depend on the terms of the individual agreement. The mere presence of leased equipment in the UK does not necessarily establish the existence of a trade carried on in the UK through a branch or agency. A company which is not resident in the UK is only liable to corporation tax on capital gains if it is carrying on a trade in the UK through a branch or agency, and the disposal is of assets which were situated in the UK and used in or held for the purposes of the trade of the branch or agency. Taxation of resident lessor/non-resident lessee There are severe restrictions on capital allowances for assets leased to non-residents. At most, 10% per annum writing-down allowances are available if, at any time in the requisite period (generally ten years from the date when the equipment is brought into use by the person incurring the expenditure), the equipment is leased to a person who:
Capital allowances are given at 10 percent per annum if certain conditions are met, in particular that the lease term is less than 13 years and the rentals payable are uniform and periodic. If these conditions are not met, no capital allowances are available at all. These restrictions do not apply if the leasing is ‘short-term’ as defined in the legislation or is so-called ‘wet leasing’ of a ship, aircraft or transport container by a bona fide UK operator. The Inland Revenue does not currently accept the view that under European law the restrictions do not apply for leases to EU lessees. Cross border leases Cross border arrangements are inevitably complex and invariably require specific advice. Leasing out of the UK into other jurisdictions is not generally economic due to the severe restrictions on capital allowances. Transfer pricing rules operate to prevent the shifting of profits cross border generally and, accordingly, may impact on the consideration that is paid under leases and leasing related arrangements. Broadly, the rules require that cross border transactions be conducted at arm’s length. For example, payments between related parties under a cross border finance lease should reflect an appropriate rate of the return for the lessor. This area is often not clear - as such, specialist advice should again be sought for particular transactions. Withholding taxes In practice, lease rental payments to non-UK residents are not generally subject to UK withholding tax. For treaty countries, the lessor would normally be protected from any income tax liability other than by withholding. An exception is that rents payable to non-residents in respect of equipment affixed to land or buildings may depending on the legal position be subject to deduction of basic rate income tax (currently 22 percent) at source. Anti-avoidance The major anti-avoidance provisions specifically applicable to leasing are described above. There are various anti-avoidance provisions which do not deal directly with leasing but which could in some circumstances be applicable to certain arrangements involving leasing. The possibility of introducing a general anti-avoidance provision has been raised in the UK in recent years, but it does not appear at present that such a provision is likely to be introduced in the short term. A decision by the Special Commissioners in the recent case of ABC Ltd v M (Insp of Taxes) (2001) SpC 300 held that a company was denied capital allowances because the purpose of expenditure was not the acquisition of plant and machinery but instead to obtain the benefit of the capital allowances. This case is important because it demonstrates that an otherwise straightforward leasing transaction will not necessarily be viewed in isolation from security arrangements, and therefore perhaps, by implication, other facts surrounding the transaction. Where there are complex leasing arrangements contemplated specialist advice should be obtained. Tax authorities’ approach The UK tax authorities continue to look closely at a number of areas where they consider there may have been scope for loss of tax. These include:
Leasing and hire purchase contracts are, in general, chargeable to VAT at the standard rate (currently 17.5 percent). Only the general position is covered below and there may be exceptions or conditions for the treatment which are not set out here. VAT rate The standard rate of VAT, (currently 17.5 percent), applies to all business supplies made in the UK by a taxable person which are not specifically zero-rated or exempted by legislation. Compulsory registration A lessor who makes taxable supplies, and is not already registered for UK VAT will become liable to be VAT registered at the end of any month if in the previous twelve months the supplies below exceed the VAT registration limit (with effect from 1 April 2001, GB£54,000):
The lessor is also required to register if at any time there are reasonable grounds for believing that the value of his taxable supplies (of a type specified above) in a period of 30 days then beginning will exceed the UK VAT registration limit. A lessor may also be required to register for VAT where he acquires a business as a transfer of a going concern (“TOGC”). The transferee will be liable to register (if he is not already registered) if the value of the transferor’s taxable supplies in the last twelve months has exceeded the registration limit or there are reasonable grounds for believing that the value of taxable supplies in the 30 days from the date of the transfer will exceed the registration limit. Voluntary registration Where a lessor is not liable to be registered for UK VAT, as long as he can satisfy Customs that he makes taxable supplies in the UK or is carrying on a business and intends to make such supplies in the UK in the course or furtherance of that business, he can register for UK VAT. Customs will register the lessor with effect from the date of application, or such future date specified. Retrospective registrations are possible with Customs agreement, but these are restricted to a date not more than three years prior to the date of application. A voluntary registration is possible even though the lessor has no UK business establishment. However, Customs may require the overseas lessor’s VAT records to be made available to them in the UK and they may require security in the form of a bank guarantee. VAT representatives Under certain circumstances, Customs may direct a lessor to appoint a VAT representative to act on his behalf for VAT purposes in the UK. This would be unusual. Treatment of asset finance transactions by type Hire purchase/conditional sale/credit sale agreement Hire purchase, conditional sale and credit sale deals are all regarded as a supply of goods. This rule applies where the possession of goods is transferred under agreements which expressly contemplate that property in the goods will also pass at some stage in the future but not later than when the goods are fully paid for. The presence of a nominal option fee to acquire the goods at the end of the hire period is deemed to constitute an 'express contemplation' that ownership of the equipment will pass to the lessee. Although the lessee pays for the equipment in instalments over the full term of the agreement, the lessor is obliged to account to Customs for the VAT on the full selling price of the goods at the commencement of the agreement. Where the finance element of the rentals is separately identified and disclosed to the lessee this element is treated as a separate supply of finance and is exempt from VAT when supplied as a UK domestic supply. If the finance charge is not separately identified and disclosed to the lessee the finance cost will normally be liable to VAT at 17.5 percent. Where this is the case, the financing cost is treated as part of the selling price of the equipment and the VAT should be charged and accounted for at the commencement of the agreement. Lease purchase Some lease purchase agreements will include a balloon payment at the end of the lease period. The lessee has the option of paying the balloon payment to receive title to the goods. If the lessee does not pay the balloon rental, then the goods are returned to the lessor. Customs’ interpretation as to whether an agreement is a supply of goods, as opposed to services, usually depends upon the value of the option to purchase fee. Generally if the option to purchase fee is exercisable at less than market value, the supply is one of goods. Where the purchase option is exercisable at or above market value Customs regard the supply as one of services. This approach is not always applied uniformly by all local VAT offices and it is therefore essential to confirm the VAT treatment of such agreements with Customs. Finance lease A finance lease is regarded as a supply of services for VAT purposes. Therefore, VAT is due on the periodic lease rentals. There is no separate exempt supply of finance. Operating lease/contract hire An operating lease and contract hire agreements are considered to be a supplies of services for VAT purposes. Therefore, VAT is due on all rentals received by a lessor. There is no separate exempt supply of finance. Special rules for particular assets Cars - being purchased There are restrictions on the ability to recover VAT on the purchase of a car. However, VAT incurred by a car lessor on the purchase of the car is likely to be fully recoverable as the car will be used exclusively for business use (i.e. leasing). The condition of exclusive business use is not satisfied where the lessor intends to:
Other cars may qualify for input tax recovery such as pool cars, demonstration cars and courtesy cars. Cars - being hired Generally, only 50 percent of the VAT incurred by the lessee on the lease rental of a car can be treated as input VAT potentially available for refund, unless:
Ships and aircraft The leasing of certain ships and aircraft are taxable supplies at the zero-rate where the ship has a gross tonnage of 15 tons or more, or an aircraft weighs 8,000kg or more, and they are not designed or adapted for recreation or pleasure. Other There are also special rules in relation to static caravans, house boats and freight containers as well as other types of equipment in certain circumstances. Domestic asset finance transactions VAT treatment for lessor Time of supply VAT must be charged and accounted for by reference to the tax point. When a tax point is created depends on a number of factors. The most important of these is whether the supply is of goods or services. Supplies of goods The “basic” tax point for a supply of goods is the date when the goods are made available/delivered to the customer. However, this tax point is superseded by an “actual” tax point which is created by the earlier of:
Supplies of services The “basic” tax point for a supply of services is the date when the services have been performed. However, this tax point is superseded by an “actual” tax point which is created in the circumstances described above. Continuous supply of services There are special rules for services which are supplied over a period of time and are charged to the customer by the issue of periodic invoices (e.g. leasing services). The tax point for such services is the earlier of:
It is possible for the supplier of continuous supplies of services to issue a VAT invoice (commonly known as an account schedule) to cover a period up to one year ahead. The tax point is then the earlier of the following:
Deposits Normally deposits will create an actual tax point when they are received, as they are treated as advance payments. A deposit taken as security to ensure safe return of the goods, and which is fully refundable, is not a supply for VAT purposes and does not create a tax point. Value of supply The value of a supply is normally the amount of the lease rental charged, or the sales value of the goods. However, where a taxable transaction is entered into between two connected parties at a value less than an open market value, Customs can, under certain circumstances, direct the value which should be used for the purpose of VAT accounting. Liability of supply VAT is charged on leasing services in the UK at the standard rate of UK VAT of 17.5 percent. However, as detailed above, the leasing of some specified types of equipment can be zero-rated. Equipment when leased and used outside the UK (or outside the EU for means of transport) is outside the scope of UK VAT. However, such equipment is likely to be subject to VAT in the recipient’s jurisdiction if the recipient is established within the EU, or may be subject to local indirect taxes if the recipient is based outside the EU. Composite and mixed supplies In general terms, a composite supply arises when goods and services are supplied together to make one indivisible supply. One VAT treatment is applied to the supply as a whole. A mixed supply arises when a number of separate goods and services are supplied together. Where the supplies attract a differing VAT treatment, the value of each supply must be identified to ensure the correct VAT treatment is applied to the appropriate value. VAT recovery issues Input VAT comprises the VAT incurred by the lessor:
The lessor is entitled at the end of each VAT accounting period to credit for so much of his input VAT as is allowable. The amount of allowable input VAT is that which is attributable to taxable or equivalent supplies made, or to be made, by the lessor in the course or furtherance of his business. VAT must have been properly charged to the lessor. VAT cannot be reclaimed on goods and services which are not used for business purposes and, where exempt supplies are made, it may not be possible to recover all input VAT incurred. Equally, input VAT cannot be reclaimed unless a valid invoice or other document or evidence of payment is held (in the case of imports that is Customs’ importation certificate, C79). If the proper evidence for input VAT is not held during the VAT accounting period in which the tax point occurred, it can still be claimed in a later period, but not in a VAT return made more than three years after the date when the VAT should have been claimed. Non-deductible UK input VAT A lessor cannot usually reclaim the following input VAT:
The European Commission is currently examining harmonising all EU Member States legislation in this area. Partly exempt businesses A lessor that makes taxable and exempt supplies is partly exempt and may not be able to reclaim all his input VAT. In such circumstances, the lessor will normally have to use a partial exemption method to work out how much of his input VAT can be reclaimed. VAT is likely to be recoverable only where it is attributed to:
Non-attributable input VAT is input VAT which cannot be directly attributed to either taxable or exempt supplies. Therefore, the proportion of input VAT which can be treated as recoverable is calculated using either the standard partial exemption method (under which VAT recovery is calculated proportional to the values of supplies carrying the right to VAT recovery) or a special partial exemption method. The latter must be agreed with Customs. Transfer of lease portfolios and lease agreements The sale of a business or part of a business (such as a lease portfolio) as a going concern is not considered a supply for VAT purposes. Therefore, no VAT is payable on the transfer of the business, subject to the following conditions:
Transfers of goods comprised in a hire purchase or conditional sale agreement together with the agreements to a bank or other financial institution are also outside the scope of VAT.
Cross border issues The leasing of equipment across borders can be complex for VAT purposes. The VAT treatment will depend on a number of factors, these being:
The guidance below only outlines the basic concepts of UK VAT in respect of overseas lease transactions and specialised advice should be sought for specific transactions. Lessors leasing out of country Goods The VAT treatment of equipment leased by a UK lessor under an agreement for a supply of goods will depend upon where the lessee is established and where the goods are located.
Services The VAT treatment of equipment leased by a UK lessor under an agreement for a supply of services will depend upon where the lessee is established and where the goods are located.
Hire of means of transport The hiring of a means of transport has special rules. Such services are generally treated as taking place where the supplier belongs when the service is provided within the EU. However, if the lessor belongs in the UK but the effective use and enjoyment of the transport takes place outside the EU, the place of supply will be outside the EU. A condition is that the means of transport must either be outside the EU or exported from the EU by the lessor at the time of the lease. Movement of goods The movement of goods from the UK to a place outside the EU is an export. Exports can be zero-rated subject to the equipment leaving the EU within the required timescales and the necessary proof of export being retained. The despatch of goods from the UK by an UK VAT registered lessor can be treated as zero-rated in the UK subject to conditions. Lessors leasing into country Goods The VAT treatment of equipment leased by a non-UK lessor to a UK lessee under an agreement for a supply of goods will depend upon where the lessee is established and where the goods are located, the VAT/business status of the lessee, and where the lessor is established. If the lessor is established (and VAT registered) in the EU and;
the goods are sourced from the lessor’s member state:- the goods are sourced from outside the EU:- If the lessor is established outside of the EU and:
the goods are sourced from another EU member state: the goods are sourced from outside the EU: Services Where equipment is leased under an agreement for services by a lessor established outside the UK, the UK lessee will be required to account for UK VAT under the UK reverse charge procedure where they intend to use the equipment for business purposes. Where the lessee is not in business, or the equipment will not be used for a business purpose, and the lessor is established:
Where the goods leased are not used in the EU, the supplies will be outside the scope of UK (and EU) VAT. Where the goods leased are used by the lessee in the UK, but are not sourced in the UK, there may be a requirement for the lessor to register for VAT in the UK so that acquisition/import VAT is correctly accounted for/recovered. Use and enjoyment provisions (place of supply) Whereas normally the place of supply of leasing services is the country where the lessee belongs and the lessee is required to account for the VAT on the supply, there are special rules where the supply of leasing services is made to a non-business lessee in the UK by a non-EU lessor. Such supplies are deemed to take place where the equipment is “used and enjoyed”, with the lessor being responsible for the VAT accounting, subject to the lessee not being registered for VAT. In these circumstances, the lessor will need to consider whether there is a requirement to be registered for VAT in the UK. Letting on hire of a new means of transport by a lessor who belongs outside the EU, to a UK lessee (where the transport is used in the UK), requires a lessee in business to account for the VAT. Where the lease is to a non-business lessee (or one who is not VAT registered), the lessor may need to register and account for VAT. Movement of goods VAT must be accounted for VAT on the importation of goods into the UK from outside the EU. If the lessee is purchasing the goods (e.g. under a hire purchase agreement) he will usually act as importer, incur and then recover the import VAT charged. Duty charged on the importation of equipment is irrecoverable. Where equipment is imported into the UK to be hired to a UK lessee, it is normally the lessor that will account for the import VAT. Subject to certain rules, the lessor can recover the import VAT by making an EU 8th or 13th Directive claim to the UK tax authorities. It should be noted that it may take six months or longer for the refund to be processed and payment to be made. Equipment received in the UK from another EU member state will be a despatch by the lessor in the country of despatch and an acquisition in the UK either by the lessee or the lessor depending on the circumstances. Lessees leasing from overseas Goods The UK VAT treatment by the lessee of equipment under an agreement for the supply of goods from a non-UK lessor will depend upon the status of the lessee and where the goods are sourced from. If the goods are sourced from within the UK the lessor is likely to be required to register and account for UK VAT on the supply. If the goods are sourced from within the EU (excluding the UK):
If the goods are sourced from outside the EU:
Services The receipt of leasing services in the UK by a business from a lessor established outside the UK will normally require the UK business to account for the VAT on the supply under the UK reverse charge procedures. Where the UK lessee is not in business, if the lessor is established in the EU, the lessor should charge local VAT on the supply. However, if the lessor is established outside the EU, the lessor may have a requirement to register for VAT in the UK and charge UK VAT on the supply. VAT accounting A lessee that acquires goods from a business registered for VAT in another member state must calculate the VAT due on the acquisition of the goods and enter it on the ‘VAT payable’ side of the VAT return account. The VAT paid is deductible as input VAT on the ‘VAT allowable’ side of the same VAT return, subject to any input tax recovery restrictions. When leasing services are received, VAT should be accounted for (based on the sterling value of the supply) in the VAT accounting period in which the payment for the services is made. A corresponding entitlement to treat that VAT as input VAT arises in the same VAT accounting period, subject to any input tax recovery restrictions. As outlined above, this can create a liability for lessees to register for UK VAT, if they are not already VAT registered. VAT recovery issues The overall effect of a UK business undertaking the VAT accounting for:
is neutral where the lessee is entitled to reclaim all the input VAT so incurred because he is fully taxable or because the input VAT is wholly attributable to taxable supplies. Movement of goods Equipment supplied under an agreement for services will not, generally, create any VAT reporting requirements in the UK for the UK lessee in respect of those goods.
Where the equipment is being supplied under an agreement which is treated as a supply of goods, and the lessor is established in another EU member state, then the receipt of the goods in the UK by the lessee is an “acquisition” in the UK. In these circumstances the UK lessee will have to report the acquisition on its VAT return. If the value of its acquisitions in a twelve month period exceeds certain limits, the lessee will have to complete Intrastat declarations.
End of lease matters Termination The VAT treatment of a payment by a lessee to a lessor to terminate a lease before the end of the lease term is complex. However, under an agreement between Customs and the Finance & Leasing Association (“FLA”), the termination payment will be treated as a supply of services by the lessor and will therefore be standard rated. Penalty payments The treatment of penalty payments depends on the circumstances in which they occur. Penalties can arise from a number of causes, ranging from default by the lessee to a request for early termination. To conclusively determine the VAT liability of a penalty payment it is necessary to examine the contract and the circumstances under which it arises. Rebates of rentals A rebate of rentals is a payment by the lessor at the end of the term of a lease of equipment. The proper VAT treatment of this payment varies according to its legal nature. To simplify the VAT treatment of such payments, Customs and the FLA agreed that no VAT need be accounted for by the lessee on any such payment provided that VAT is not identified on any invoice or other document issued. Therefore, VAT should not be accounted for on this transaction. However, VAT must be charged and accounted for on the sale of the equipment (a supply of goods) in the normal way. This VAT treatment is, however, not compulsory and, if preferred, the normal VAT rules can be applied. Repossessions/sale of repossessed assets Where goods are supplied under a hire purchase or conditional sale agreement (including agreements with a reservation of title clause), all VAT due under the agreement is payable at the outset. If the goods are subsequently repossessed or returned, there is no supply to the owner for VAT purposes. On repossession of goods not fully paid for, the lessor cannot issue a credit note for the amount invoiced and substitute a new invoice for hire charges in respect of the period of use. However the lessor can claim bad debt relief on the unpaid amount. Special rules apply for periods prior to this and for the sale of goods covered by special VAT accounting schemes. Other VAT procedures Bad debt relief The lessor must account for VAT on its supplies even if the debt, including the VAT, becomes irrecoverable. The lessor cannot reclaim the VAT accounted for by issuing a credit note. Instead, special procedures must be followed to obtain bad debt relief. A qualifying period (6 months) will need to elapse before any repayment of the VAT is claimed. Stamp Duty Land tax (SDLT) SDLT is a new tax on land transactions. Although it replaces stamp duty on 1 December 2003, it is fundamentally different from stamp duty. The changes, which in detail are complicated, will affect everybody acquiring UK property or taking a lease of UK land and property. The rules in relation to Stamp Duty on plant and equipment remain the same, and the current position is set out below. Acquisition of the equipment by the lessor Stamp duty is charged on the documents or instruments effecting a transaction, rather than the transaction itself. Therefore, where equipment (such as moveable plant and machinery) is transferred by physical delivery there is no document of transfer upon which to charge stamp duty. Where title to the equipment will be transferred by a bill of sale or other document of transfer (and this can be difficult to avoid in the case of fixtures attached to land and buildings), ad valorem stamp duty will generally be payable by the transferee. A detailed receipt signed by the vendor may also be stampable as a document of transfer but a mere written agreement to transfer equipment is not stampable. The following rates of stamp duty apply to documents of transfer:
There is a specific exemption from stamp duty on all instruments for the sale or transfer of any ship or vessel but this exemption does not extend to aircraft. Grant of the lease to the lessee There is no stamp duty liability on the grant of a lease for moveable equipment. The grant of a lease for fixtures to land may be chargeable to stamp duty as a lease for land by reference to the premium and/or rent paid (see comments on the new SDLT above) . Assignment by the lessor of the equipment and the rights under the lease When the equipment to be transferred is subject to a lease or hire-purchase agreement, what is actually being transferred is not just the title to the equipment, but also the benefits of the lease (e.g. rental). These two elements are treated for stamp duty purposes as separate transactions, with consideration apportioned to each element by reference to commercial value. There will be ad valorem stamp duty payable on the document transferring the benefits of the lease. This document is usually the agreement. The transfer of the equipment element of the transaction will be free of duty unless a document of transfer is required to resolve the practical difficulty of title passing by delivery where the actual possession of the equipment remains with the lessee. Where the subject matter of the lease is fixtures attached to land, the new SDLT may be in point. Assignment by the lessee of its interest under the lease Stamp duty is payable on the consideration paid by the purchaser, whether the lease is for fixed or moveable equipment. Other Issues Exchange controls The UK has no exchange control legislation in operation. Customs duty Customs duty is payable on most commercial importations into the EU from outside the EU and is normally levied on a value-based rate. In the case of leased equipment, the lease cost is not normally an acceptable cost to declare for customs duty purposes. If no sale exists for the product on import into the EU, some form of open market value will have to be ascertained and declared. Various reliefs exist to either mitigate the duty cost or improve the cashflow implications of payment of duty. Trade tax, transfer taxes and other capital taxes There is no net worth tax, trade tax or similar in the UK. Investment grants, subsidies and tax incentives Grants may be available in certain restricted circumstances and local advice should be taken. Grants are usually taxable, either directly or by deduction from the amount on which allowances are given. The benefit of any such grants can be passed on to the lessee in the form of the lower lease rentals. KPMG Contacts For further information contact: Philip Marwood (Tax) KPMG Tel 44 20 7311 1000
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Saturday, September 11, 2010