Reform of Corporation Tax: Leasing
On 21 July the Government announced that, as heralded in its December 2004 Pre
Budget Report, changes will be made as to the UK taxation of plant and machinery
leases. For long funding leases (see definition below) of plant or machinery capital
allowances, like loan finance will reside with the lessee, with the lessor being taxed
on its finance margin only. The changes, albeit not yet fully determined nor fully
comprehensive, are to take effect from 1 April 2006.
The rationale promulgated for the changes is to remove a perceived distortion
between loan and lease finance where the terms of the lease make it an in substance
financing. The real driver remains the significant risk that, if challenged, the UK’s
restrictive capital allowances rules which effectively prevent leasing to non-UK
resident / non-UK taxpayers, would be held to be non-EU compliant.
Since December 2004 there has been dialogue between the relevant officials in the
Treasury and HMR&C and the leasing industry and its advisers. This discussion has
to some extent been reflected in the revised proposals contained in the July technical
note but no updated draft legislation has been provided. Although there have been
some commercial improvements to the proposals there is a worrying amount of
uncertainty around key areas such as the grandfathering rules and definition of plant
affected by the new rules for the purposes of property leases for example.
The rest of this note sets out the key areas of change since December 2004 and
identifies areas where further consideration / action is urgently required if we are to
have a functioning system by the April 2006 deadline. Representations to the Revenue
on the latest consultation have been invited by 14 October 2005. The draft legislation
issued in December 2004 has not been updated for the latest developments, and it is
not clear when a further draft will be issued.
Changes to the definitions
What is a plant or machinery lease ?
It is now intended that a plant or machinery lease for the purposes of the new rules
should be limited to “leases and transactions that are properly accounted for as leases
under GAAP” (ie UK GAAP or IAS).
Although the second test - the accounting – should be straightforward the first –
whether there is a lease or not (a legal matter) - may give rise to some dispute.
Where the transactions fall within the above, they will constitute a funding lease if
they satisfy any of the following:
1) The transactions constitute a finance lease under GAAP (UK GAAP or IAS as
appropriate to the relevant taxpayer), or
2) The net present value of the minimum lease payments (ignoring payments for
ancillary services) is more than 80% of the fair value of the asset (formerly 75%),
or
3) The minimum term of the lease is more than 65% of the remaining useful
economic life of the asset (formerly 50%).
The specialised assets test, formerly included in the December 2004 proposals, has
been dropped as it added little and created unnecessary uncertainty.
Assets leased more than once
An asset that has been leased previously by the current lessor and whenever
previously leased has been on a lease that was not a long funding lease (or would not
have been if the new regime had then applied) will not be a long funding lease if the
total terms of such previous leases exceed 65% of the useful economic life of the
asset. This is to prevent the last of a series of operating leases automatically becoming
a long funding lease.
What is a long funding lease ?
A funding lease will not fall within the definition of a long funding lease (and
therefore within the new regime) if it has a term up to 5 years or between 5 and 7
years if it meets certain conditions which prevent back loading of the rentals. These
terms have increased from the 4 and 6 years respectively suggested in the December
2004 proposals.
Start date and grandfathering
As noted above the start date for the new regime is 1 April 2006.
The existing regime will continue to apply for leases of plant and machinery where
there exists a written lease contract between the lessor and the relevant lessee and the
asset is made available to the lessee before 1 April 2006.
The existing regime will also apply where a written agreement (“the Existing
Agreement”) was entered into by the lessor and lessee before 21 July 2005, the asset
is under construction by 1 April 2006 and the completed asset is made available
before 1 April 2007 under a final lease agreement. The final lease agreement must be
between the same lessor and lessee as the agreement subsisting at 21 July 2005; it
must be finalised before 1 April 2007 and must not be materially different to the 21
July agreement.
The 1 April 2007 deadline may be extended to 1 April 2009 for assets which have
extended construction times. There are rules as to construction and similarly to the
April 2007 rules the final lease must be between the same parties and be materially
the same as the agreement existing on 21 July 2005.
The rules do not define Existing Agreement, but state that it should contain sufficient
detail so as to be able to determine whether the final lease agreement is materially the
same as the Existing Agreement. It notes that the Existing Agreement should set out
its main terms including identifying the particular lessee, details of the assets, the
lease term and expected rentals. The risk and uncertainty as to what constitutes an
Existing Agreement for these purposes is placed on the taxpayer.
There are references to provisions to deal with combined assets and apportionments
for leases which may contain expenditure in both the existing and new regime.
Time apportionment and other anti-avoidance provisions
On the positive side the technical note indicates, following industry lobbying, that the
time apportionment rules introduced in 1997 (which restrict finance lessors’ capital
allowances in the year of acquisition), will be removed for finance lessors and only
extended to operating lessors where in both cases the lessor does not use the group’s
normal accounting year end date. Where the lessor does not adopt the group year end
the apportionment rules will apply to operating leases which are funding leases for tax
purposes and have a term in excess of 4 years but not more than 7 years.
The note also states that the overseas leasing rules will not apply to leases entered into
after 1 April 2006, subject to the transitional rules referred to above. However, the
paper ominously refers to the possible retention of some of the overseas leasing rules
for future leases.
The position on other existing avoidance provisions is left open and it will be
interesting to see if the Government takes the opportunity to at least remove some
lease provisions which duplicate or have been superseded by other provisions.
Chains of leases
The latest technical note contains positive developments on the position of lease
chains. The December 2004 paper raised the distinctly unattractive position of
denying any capital allowances where there was such a chain. The revised proposals
establish that the lessor’s / headlessor’s right to claim capital allowances should take
precedence over the lessee’s right. This has been extended to cover non UK
taxpaying lessors if they would be entitled to claim capital allowances were they
within the charge to UK corporation tax or income tax. Accordingly where a lessee
takes the view that it has a long funding lease it must establish that no lessor or head
lessor is (or would be) entitled to claim capital allowances. There will be provisions
dealing with the exchange of information from the lessor to the lessee. There is a
rather unhelpful suggestion that lessees might be entitled to neither capital rent
deductions nor capital allowances if they cannot establish whether a superior lessor is
entitled to allowances.
Hire Purchase
The existing rules which transfer tax ownership to the lessee under a hire purchase
agreement will be extended to apply to contracts with non-UK taxpaying business
lessees.
Property leases
The general rule is that long funding leases of plant or machinery will be within the
new regime. For property leases which include “incidental plant or machinery”, the
existing rules will continue to apply. The line between incidental and non-incidental
plant or machinery is not clearly defined and such uncertainty will be very unhelpful
for longer term property projects where there is no existing 21 July agreement.
Leases to Tonnage Tax companies
As noted in December 2004 these will be exempt from the new regime, provided the
lease is either direct to the tonnage tax company, or via a single fellow group member
of the tonnage tax company.
Areas on which the Government welcome comments
• The possibility for lessors (finance and operating) to elect to come within the
new regime and be taxed on an accounts basis,
• The proposals fore hire purchase,
• The proposals for chains of leases and the prevention of double allowances,
• Possible restriction of first year allowances of lessors of environmentally
beneficial technology.
Comments should be received by 14 October 2005.
Other areas of uncertainty
The Government have identified a limited number of areas on which they request
comment. For taxpayers, lessors and lessees, the changes will require significant
changes in their compliance systems and tax returns. In many respects the new rules
will add further rules rather than result in simplification. This is probably an
acceptable price to pay given the flexibility needed to deal with commercial
arrangements such as chains of leases, but taxpayers will need certainty in applying
such complex provisions. Other key areas of concern / uncertainty include:
• Clarity as to what is a lease for these purposes,
• A comprehensive definition of incidental plant or machinery in respect of
property leases,
• Further extension of and clarity in respect of grandfathering of leases and
agreements to lease. Imposing, without notice, an unclear definition of what is
an existing agreement to lease is commercially damaging to longer term
property and other projects,
• An early indication as to which existing leasing anti-avoidance provisions are
to be abolished and what form any new provisions dealing with the new
regime will take.
• Draft legislation covering the current proposals should be issued shortly and
certainly well before Spring 2006. This is required to clarify a number of
terms contained in the technical note, for example what represents the term of
a lease for the purposes of determining whether there is a long funding lease?
Jonathan Vines
Tax Partner –KPMG Leasing and Asset Finance Group
26 July 2005

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation