Financially, this year has been a little more difficult for businesses due to the Covid pandemic, and companies are starting to feel the pinch of months of lockdown, which is adding to financial pressures. Dilapidation is one of the many ways that existing assets can be used to reduce tax burdens on businesses.
Dilapidations are infringements of the terms of a property lease to repair a building. Such breaches can take many forms, but common examples include redecorating, replacing carpets, and repairing a broken window. The number of claims served by landlords against tenants has increased in recent years, according to press reports. This is not surprising given the state of the commercial real estate market at the time.
With little capital available for large-scale redevelopments, landlords are re-conditioning their properties in a more cost-effective manner. Smaller repairing and decorating jobs have become more advantageous, with landlords increasingly seeking compensation from tenants. This has resulted in a significant increase in the use of dilapidation schedules.
Provisions for Dilapidation
A landlord can issue a schedule of dilapidations at any time during the tenancy and up to several months after the agreement ends. Typically, a tenant would be advised to include a dilapidation provision in their profit and loss statement to account for the future cost of the schedule.
If a tenant makes a provision for future dilapidations, there is an opportunity to claim tax deductions at the time the provision is made. This is due to the fact that the provision is made in anticipation of future expenditure on the premises’ repair. The provision will be a specific provision if the tenant meets the following criteria as outlined in Financial Reporting Standard 12.
- The entity must have a present obligation as a result of a past event (this is most likely a contractual obligation)
- A transfer of economic benefits is likely to be required to settle the obligations
- A reliable estimate of the amount of the obligation must be made.
The property in question must also be used for commercial purposes, and the lessee must be responsible for repairs and must deliver the property in the same condition as it was at the start of the lease. If these conditions are met, the tenant may be eligible for tax deductions for the dilapidations provision, which will reduce their taxable profit.
The provision is taxed differently depending on whether it is a general provision or a specific provision. A tax deduction is not permitted for a general provision, but it may be permitted for a portion of a specific provision.
The dilapidation to be performed may include a variety of works that are either capital or revenue in nature for tax purposes.
Capital works include the following examples:
- the cost of rebuilding the leased premises, or
- the cost of re-establishing any portion of the leased premises demolished by the lessee, or
- the cost of demolishing any structure added by the lessee.
Expenses for deferred repairs are deductible to the extent that the cost would have been deductible if the repair work had been completed during the lease term.
Section 53 of the Corporation Tax Act of 2009 states that the proportion of the specific provision that relates to capital works is not tax-deductible. However, the remainder of the provision is fully deductible.
The capital proportion of the provision made, as established, is not tax-deductible. Nonetheless, once the lease expires and capital expenditure is incurred, a portion of it may be eligible for capital allowances under the Capital Allowances Act of 2001.
Timing and Adjustments
When a dilapidations provision is made, the amount assigned to revenue works is tax-deductible as of the date the provision is taken. A provision is deductible if and only if the following conditions are met:
- the profit would not be adequately stated if the obligation was not taken into account;
- a provision is made in the accounts; and
- a sufficiently reliable figure is used.
This means that at the end of the lease when the final works are finished and the total cost of these works is known, an adjustment will almost certainly be required. If the provision exceeded the actual expenditure, the difference is added back to taxable income and taxed in the year of completion. If there is an under-provision, the excess actual expenditure is deductible for tax purposes within the year.
Where a tenant has previously only established a general provision, Bourne has experience valuing the dilapidations that will be required at the end of the lease to provide the necessary basis for treating part of the general provision as a specific provision. This amount can be backdated and used as a catch-up deduction in the earliest open tax return.
As a result, despite the fact that the actual cost of dilapidations occurs within a relatively short time period at the end of the lease term, tax deductions can be taken far in advance of the expenditure being incurred, establishing a potentially valuable timing benefit.