Capital Allowances for Landlords on Tenant Fit-Out Contributions
Landlords can claim CAs on capital contributions towards the tenant’s fit out. The type of capital allowance the landlord may claim is stipulated by contract wording in the agreement for lease. Ideally the wording should be allocating the fastest allowances such as first year allowances with the balance of the contribution being for writing down allowances and SBAs if applicable.
What Are Capital Allowances?
Capital allowances are a form of tax relief that allows landlords to deduct the cost of qualifying capital expenditure from their taxable profits. Expenditure qualifying for capital allowances includes fixtures and plant which may either qualify as general pool or special rate pool allowances. These pools are claimed annually at 18% (14% from April 2026 onwards) and 6%, respectively, on a reducing balance basis until the property is either sold or the entire balance in the pools are fully claimed. For qualifying general pool and special rate pool expenditure, the annual investment allowance (AIA) may also be available, provided the claim is made in the same accounting period in which the asset was purchased. Claiming the AIA means the general pool and special rate pool can be written off in the first year at 100%. There is a limit on the amount of AIA available up to £1m.
For non-qualifying capital expenditure incurred on the structural element of a commercial building (such as walls, hard landscaping, steel frames etc.), these will not qualify for the plant and machinery allowances mentioned above. Instead, provided the expenditure and contract was entered into on or after 29 October 2018, SBAs may be available. This allowance is written down on a straight line basis of 3% per annum from when the building is first brought into non-residential use (i.e. when a tenant first moves in). It is important to note, however, that claiming SBAs may result in the base cost of the property to reduce, thus increasing the chargeable gains when landlords come to sell their property. The amount is the same amount that have been claimed. By claiming SBAs, it is thus not a true tax relief, but rather a cash flow benefit. Therefore, landlords who plan to sell in the short-term are usually not recommended to claim SBAs, and instead pass on the full amount to the next buyer and potentially they could hold higher bargaining powers during the negotiations stage.
Depreciation on capital assets is not an allowable deduction for UK tax purposes and must be added back when calculating taxable trading profits. CAs were therefore introduced to provide tax relief in the form of a deduction at their specific rates to incentivise businesses to invest more.
CAs are relevant for commercial landlord as they can provide generous tax relief for otherwise non-deductible capital expenditure on building works to properties that they own. By claiming CAs, the taxable rental profits will reduce, meaning landlords will pay less tax and as a result will see an improvement in their cash flow over time. This can be very beneficial for large capital expenditure made to improve the letting space for tenants as not only can landlords claim CAs on qualifying expenditure but can also enhance their buildings to make finding occupiers easier.
Landlord Contributions to Tenant Fit-Out Works Explained
What Is a Landlord Contribution?
Landlord may choose to attract potential tenants to take up vacant space via incentives like cash contributions, capital contribution to tenant fit out works or a rent free period.
In the landlord’s point of view, offering capital contributions towards tenant works can be a tax efficient method to incentivise tenants to rent out their space. This is because these contributions can be offset against the landlord’s trading profits provided there is appropriate AfL wording that clearly states the landlord is eligible to make a claim for CAs.
Contributions will normally be documented within the agreement for lease and not the actual lease agreement. It is structured in a way that clearly defines the landlord’s contribution as a fixed amount plus VAT (if applicable) and the various qualifying capital allowances such as plant or machinery, special rate plant, SBA assets etc. The wording may mention “The Landlord shall pay the Landlord’s Contribution as a capital contribution towards the cost of the Tenant’s Fitting Out Works”. The agreement for lease should also state which order the contribution is applied to the various allowances. This is vital as it avoids later disputes as to which party will benefit from what allowances. It is also good practice to mention the relevant legislative sections of the Capital Allowances Act 2001 to secure the allowances and avoid a double claim. The relevant sections include s538 CAA2001 which treats capital expenditure as being incurred by the landlord for capital allowances purposes and s532 CAA2001 which restricts the tenant from claiming on the capital contribution. If available during the drafting of the AfL, it is also of merit to include the contractor’s agreed pricing schedule to provide further clarity as to what works are to be paid by the Landlord and an obligation on the tenant to supply copies of the fit-out invoices and a reconciliation of those invoices.
Can Landlords Claim Capital Allowances on Tenant Fit-Outs?
Landlords must not be connected with the party in which they are making the contribution to, must be a UK tax payer and must hold the contribution in their capital account to be eligible to claim allowances.
Capital expenditure, or Capex, is money spent on assets which are intended to improve the value of the building whilst revenue expenditure is money spent on repairing existing assets but not necessarily enhancing the character of the building.
Capital expenditure on plant and machinery only qualifies for CAs if the party (in this case, the landlord) both incurs the capital expenditure and owns the plant and machinery as a result of incurring it. Ownership can either be statutory or deemed, aforementioned above, s538 CAA2001 deems the landlord as owning the qualifying plant and machinery that was funded by way of capital contribution.
One rule for claiming CAs is that the asset that is owned by the landlord must be used for the purposes of a qualifying activity, otherwise it will be non-qualifying. Whoever has the benefit and risks of the asset in their business is the one with the “control”
To solidify ownership and control, the lease terms should dictate who is treated as incurring the capital expenditure and owns the assets as a result. It is important to apply correct terms as a poorly drafted lease may prevent both parties from being entitled to claim CAs.
Common Qualifying Expenditure in Tenant Fit-Outs
- Mechanical and electrical installations – Considered background plant and machinery
- Lighting, heating, ventilation, and air conditioning systems
- Electrical power, cabling, and data infrastructure
- Fire protection, security, and life-safety systems
- Fixtures that may still qualify despite tenant occupation
Capital Allowances vs Lease Incentives
Rent free periods are usually given as an incentive to the tenant who have agreed to spend their own money fitting out the space for their own needs. The length of the rent-free is dependent on the agreement between the two parties but are usually for at least one month. Capital contributions are alternatively offered to cover or subsidise the expenditure of the tenant fit out. It is potentially more beneficial for landlords to offer a capital contribution towards tenant fit out works as they may be able to use CAs to reduce taxable profits, provided they are eligible to claim allowances. Alternatively, rent frees are not eligible for capital allowances.
Aforementioned above, the order in which CAs may be claimed is dependent on the wording in the AfL. The wording must clearly state the amount of landlord capital contribution, the definition of the CA pools and the amount to be allocated to each pool. A brief example would be, £x capital contribution to be made on tenant fit out works, where the landlord shall be entitled to claim 100% of the contribution as qualifying expenditure attracting: full expensing in the first available chargeable period, followed by 50% FYA for special rate pool, followed by general pool, followed by special rate pool, followed by SBAs. Note the faster allowances such as the 100% FYA for full expensing is mentioned first as these allowances allow the landlord to claim the full cost in the first year.
Poorly drafted AfLs may make it unclear which party will incur qualifying expenditure and what happens to the fixtures when the lease expires. Examples include: no clear schedule of qualifying items, no mention of ownership upon lease expiry and no mention of which items can be claimed allowances on by the landlord and tenant. If the above are present, there is a risk that the landlord capital contribution is treated as a reverse premium, and thus is taxable as income to the tenant.
Capital Allowances and Commercial Due Diligence for Landlords
It is important to agree favourable terms before the lease is completed as the opportunity to claim allowances on capital contributions may be lost to the tenant. It is crucial for landlords to have specialists draft wording during the agreement for lease stage to prevent disputes on what the contribution was spent on.
The tenant may have employed their own CA specialist who have added wording that whilst the landlord is eligible to claim, they may only claim on the slowest allowances (SBAs, integral features wda) and therefore is unlikely to benefit from the first year allowances. To maximise tax relief, landlords should make it clear that they are entitled to claim on the fastest allowances followed by slower allowances on the remaining contribution (if applicable).
Tenant fit out works can affect future property sales/refinancing by the dilemma of who legally owns the assets, whether the works are of high spec or is generic and what happens to the capital allowances at sale. If the tenant fit out works were funded by the landlord through a capital contribution, then the ownership usually falls with the landlord (subject to AfL wording). At sale, any unclaimed CAs may either be kept by the seller (i.e. the landlord in this scenario) by fixing the disposal value at £2 or transferred to the buyer at any amount up to the unclaimed amount via an s198 CAA2001 tax election.
The latter scenario may be useful if you know the buyer is tax-paying and you do not need the available allowances after the sale. A landlord-funded generic fit-out (i.e. CAT A) may support higher ERV and lower void assumptions on sale, but of course bears more upfront capex which can partly be offset by CAs. Landlord capital contributions may also increase the base cost of the property which may decrease CGT payable or even create a capital loss at sale. For lenders, tenant funded fit-out arrangements may be seen as stability, particularly where there is a long lease and the tenant incurred significant capex. As a result, provided the tenant covenant is strong, lenders may be more comfortable with leverage.
Alternatively, where landlords have made contributions, this is seen as a lease incentive, as essentially the landlord is partly giving up future rent to fill a vacancy. As a result, lenders will restate the headline rent to an effective rent, being the cost of the landlord works spread out across the terms of the lease. This effective rent is lower than the headline rent as it reflects the incentive provided by the landlord, and the lenders will calculate their loan-to-value and margins based on these facts. The actual works carried out by the landlord is also very important, as generic assets may be more attractive and easier to rent out to potential tenants, whereas highly tenant specific assets may cause higher capex for removals, higher reletting costs etc. and this may result in lenders giving lower LTVs.
Interaction with Tenants and Lease Structures
Landlords can claim CAs where they incur qualifying capital expenditure on plant and machinery held in its property business within a commercial property. Similarly, tenants can claim CAs provided they incur qualifying capital expenditure that is not funded by the landlord via a capital contribution.
Lease and side letters should clearly identify who is incurring the expenditure and what the expenditure is paid for (i.e. plant), who is keeping the assets when the tenant lease expires and a schedule of historic expenditure and ownership to avoid losing entitlement when the property is being sold.
Where landlords and tenants claim allowances on the same expenditure/assets, HMRC may disallow one claim and charge penalties. Therefore it is crucial to determine the allocation of allowances in the AfL. If pooling and fixed value requirement is not met, allowances may be lost at point of sale.
Before lease renewals, there needs to be a clear understanding of who owns the existing plant and machinery and who is entitled to the allowances. If the landlord is offering new contributions, the existing assets may be stripped and therefore new allowances may arise. Subject to lease terms agreed, tenants may have to make a dilapidation payment to reinstate the space to its original before fit out works were done. These works may be repairs or capitalised items and, again, assets may be stripped and therefore a balancing adjustment may occur in the hands of the landlord. During the sale of a commercial property, clear CA records can assist in price negotiations. Where it is ambiguous on whether CAs have been claimed or transfers are not properly documented, this can have a negative effect on the price, particularly if the buyer is a tax-paying entity.
When Capital Allowances May Not Be Available
Revenue expenditure – Aforementioned above, the accounting treatment of the expenditure must be capital (investment) to be eligible.
If tenants incur qualifying expenditure with their own money and is not reimbursed in the way of a landlord capital contribution, then the tenant is usually entitled to claim CAs on that expenditure.
There is a restriction in claiming CAs on properties defined as dwellings per s35 CAA2001. Dwellings include AST, student accommodations, HMOs. Where residential properties are let to multiple occupiers, like in PBSAs and HMOs, CAs may be eligible in communal areas such as halls, corridors, stairwells and externally. Assets residing within the living spaces like bedrooms are denied from claiming CAs but revenue expense may instead qualify if the asset was replaced on a like-for-like basis.
