Capital Contributions in Commercial Lettings

COMMERCIAL PROPERTY/CONSTRUCTION

Capital Contributions in Commercial Lettings

Can capital contributions benefit both landlords and tenants? Andrea McIlroy-Rose considers a few of the pitfalls.

The use of capital contributions in commercial lettings has become extremely common, particularly in the current economic climate where landlords need to provide attractive incentives for incoming tenants. This article considers some of the advantages and disadvantages in using this type of payment.

Traditionally, rent free periods and tenant's break clauses have been used by landlords to encourage tenants to enter into leases. However, unlike these incentives, the payment of capital contributions to tenants can provide potential benefits for both parties.

Contributions

In a commercial letting a capital contribution is usually a sum of money paid to a tenant by a landlord in consideration for the tenant carrying out works necessary to make the property ready for occupation by that tenant. The main advantage for a tenant is that in paying for these works the landlord reduces the tenant's initial start up costs and therefore assists its cash flow. The main advantage for a landlord is that he may be entitled to claim capital allowances in relation to the whole or part of this capital contribution if the correct procedure is adopted.

Capital Allowances

Capital allowances are essentially the only form of tax relief available for capital expenditure in relation to commercial property. They can have a significant impact on the after tax cost of an investment depending upon the amount that the landlord can claim. However, as with most advantageous tax breaks, there are disadvantages and pitfalls that are often overlooked by landlords and tenants.

Pitfalls

The first consideration for landlords is that capital allowances are not an automatic entitlement and have to be claimed. In order to maximise the value of the capital allowance claimed, the wording of the capital contribution clause must be carefully drafted and the landlord needs to follow a specific procedure in preparing the claim.

For example, it is not sufficient to state that the landlord will pay a capital contribution to the tenant in a specific sum. The clause should state that the landlord is to be entitled, in accordance with the Capital Allowance Act 2001 (Sections 537 and 538), to claim all capital allowances in respect of the tenant's works up to a maximum amount of the value of the capital contribution. A provision should also be incorporated requiring the tenant to provide a specification and costing for its works to assist the landlord's claim.

In relation to the claim itself, a specialised firm of accountants or capital allowance specialists should be instructed to advise, in conjunction with legal advisers, on the wording to be incorporated into the documentation. They can also prepare the claim and deal directly with the Inland Revenue on the landlord's behalf.

Scheme

The main consideration for tenants in accepting a capital contribution is the Construction Industry Scheme, developed by the Inland Revenue to prevent tax avoidance in the building industry. A capital contribution, that is essentially a contribution towards a tenant's works, could fall within the ambit of the Construction Industry Scheme.

Under that Scheme, if a tenant receives a payment in this form, he must obtain a Scheme registration card or certificate, subject to a few limited exceptions. If a tenant is a certificate holder, he is entitled to receive the capital contribution payment gross without deduction of tax. However, statistics show that it is only larger tenants who are likely to hold certificates and therefore this tax exemption applies to very few. If a tenant holds a registration card, he is entitled to receive a capital contribution payment from the landlord but only after the deduction of tax. If a tenant does not have either a certificate or registration card then the landlord is not supposed to make a payment at all.

The repercussions of this Scheme are still being considered but the requirement for registration by a tenant may significantly reduce the attractiveness of capital contributions as an incentive.

Premium

If the capital contribution does not relate to works it is actually a reverse premium. Whilst a reverse premium should not fall within the Construction Industry Scheme, it would prevent the landlord from claiming capital allowances on the sum. It is because of these conflicting difficulties that the parties often revert to using the more straightforward incentives such as rent free periods.

In summary, it is possible for capital contributions to benefit both landlords and tenants but only if both parties proceed with care and seek early specialist advice.

Andrea McIlroy-Rose is a Partner in the firm's Commercial Property Department specialising in development, retail leases and construction. Andrea can be contacted at andrea.mcilroy-rose@lestrangeandbrett.com

Quote: