Lee Sharpe looks at tax aspects of modernising property and the risk of disallowance as improvements that constitute capital expenditure, losing income tax relief in the property business.
The government (HMRC) has become increasingly worried about the volume of small and medium-sized enterprise research and development (R&D) tax credit payments where a company claims to have undertaken eligible R&D activity (and it is important to keep in mind that only certain types of R&D may qualify – there are a lot of criteria).
Roughly a year ago, HMRC delegated much of its scrutiny of R&D claims to its Individual and Small Business Compliance (ISBC) department, whose ‘Campaigns and Projects’ team (that typically deals with high-volume ‘One to Many’ or ‘nudge’ letter scenarios such as where bank interest income appears to be missing from tax returns) is on the case.
This high-volume approach appears to be necessary, given the substantial proportion of R&D claims now being reviewed. HMRC justified this approach by pointing out the high proportion of claims it has then found to be defective. But this assertion warrants careful scrutiny. For instance, HMRC has apparently argued that its ISBC teams do not need specialist technical knowledge of the R&D tax regime, to be able to manage enquiries specifically into R&D claims (and having seen some of the correspondence in an apparently typical ISBC case, one might well wonder how much technical acumen it does, in fact, require just to say “no”, “I disagree”, or “you have not provided enough information”, to every point a claimant makes.)
Let us turn now to another ISBC nugget that graphically illustrates such technical knowledge in action.
Landlords claiming repairs to property
HMRC started a ‘one-to-many’ campaign specifically focusing on landlords in December 2023. HMRC had undertaken a review of 2021/22 tax returns received that had included property income, and targeted those taxpayers whose repair costs it deemed likely excessive because it suspected the miscreant taxpayer had wrongly claimed capital expenditure on the property as allowable repairs:
“[…You] may have claimed too much tax relief for your property repair costs. Our data suggest that your expenditure is higher than others with a similar income” (I suspect here that HMRC meant “a similar level of property income” rather than other people who also had property income; but perhaps I give HMRC too much credit).
Veteran advisers will be aware that HMRC has a long and disappointing history of blunt force trauma by statistical analysis going back many years. But I should like to highlight the following example that HMRC gave in that letter, of capital expenditure it warned should not have been claimed:
“[Upgrading] a central heating boiler from an older, less efficient model”.
Improved materials and technology
I remarked at the time that I found HMRC’s suggestion (that replacing a boiler from an older or less efficient model was a capital improvement) to be quite disingenuous. It is well established that merely adopting modern techniques and materials that are inherently ‘better’ will not change an allowable repair to a disallowable capital improvement. The case Conn v Robins Bros Ltd [1966] 43 TC 266 is often referred to as a good example of old-fashioned materials being replaced by modern and superior materials, using modern building techniques but without there being such deliberate enhancement of the overall asset – the building – as to require disallowance as capital improvement.
I feel I am almost obliged to mention the parallel treatment of double-glazing if and when replacing single-glazed windows – practically ubiquitous and assuredly an allowable repair in almost all cases – as accepted by HMRC in its Business Income Manual at BIM46925 (see also BIM35455).
Thankfully, HMRC has since issued a follow-up correction to all the taxpayers who were targeted in the original campaign:
“Our letter included misleading advice. We told you that ‘upgrading a central heating boiler from an older, less efficient model’ is an example of an expense you can’t claim tax relief for. [sic]
This isn’t accurate, and we’re sorry for the mistake. You may make an upgrade like this due to an advance in technology and the new item does broadly the same job as the old one. If so, we’d generally accept this as an allowable repair.”
I have emphasised the key sentence, that probably needs its own translation or explanation into clear English, but readers will get the gist. I prefer the following explanation from the New Zealand case Auckland Gas Co Ltd v CIR [2000] 73TC 266:
“It is often that, with improvements in technology, a replacement part is better than the original and would last longer or function better. That does not, of itself, change the character of the larger object or hence the appropriate description of the work” [italics added].
In this context, the “replacement part” is the new boiler, and “the larger object” is the rental property – the entirety of the asset that is being repaired.
Improved standards approved
Somewhat closer to home, the case Hopegar Properties Ltd v HMRC [2013] UKFTT 331 (TC) is helpful:
“It cannot be expected that a [builder] having modern and improved components would elect to use outdated and inferior materials to repair an asset especially where there is a legal obligation to observe current standard[s] of safety and repair...
The Tribunal finds that upholding modern standards of road repair, especially when required by law and the local authority does not, of itself, make the expenditure capital.”
That tribunal was also sympathetic to the fact that, when repairing parts of a road that had been built in the 1960s, it was reasonable to cater for modern lorries that now weighed up to 40 tonnes, and were up to 18m long; the overall effect of the works had been to return a functional carriageway at the start of the road network.
But what standard?
However, I think it would not be safe to assume that this case supports the contention that repairing something to modern standards is always a repair, never capital.
For example, if a landlord is converting a rental property to a house of multiple occupation (HMO), and replaces doors and the fire alarm system to a higher rating to comply with the Local Authority’s insistence on a higher standard specifically for HMO properties, I suspect HMRC would argue that the landlord is not simply keeping pace with standards relating to generic property letting. Rather, he is changing lanes to a new set of standards – arguably amounting to a capital improvement (likely in the context of such work running alongside structural changes that themselves rank for capital treatment).
In this vein, I should also acknowledge the case Balnakeil v HMRC [2021] UKFTT 0193 (TC), which spent some time considering the admittedly very substantial costs relating to reinstating the roof of a listed building, and held that the costs amounted to capital expenditure on the outright replacement of the roof as an entire asset in its own right, rather than simply making good a part of the building. In other words, the judge believed that replacing the roof of the property was not akin to replacing the screen of a computer (a repair) but more like replacing the computer itself – the capital asset in its entirety:
“While maintenance expenditure for replacing missing or broken slates is undoubtedly revenue, when the roof is completely overhauled as to become a replacement roof, the expenditure is capital.”
The irony of this case is that much of this expenditure was incurred because it was a listed building and the owners were obliged to bring it back to exactly the same standard as it had been originally, using traditional materials and techniques. There is much to dislike about this case.
Conclusion
It is good that HMRC has been moved to remedy its opening letter, that was seriously misleading, and could have dissuaded conscientious landlords from claiming relief for ‘better’ boilers, etc. – or even put them off getting a new energy-efficient boiler in the first place. What is concerning is that the original guidance in the first letter had (presumably) been vetted and approved before being sent out. Will things worsen as HMRC strives to simplify and automate its decision-making processes?
