In an unusually wide-ranging consultation, the government is seeking views on possible reforms to tax capital allowances, the system by which companies offset the cost of new equipment and other assets against taxable profits, reducing their tax bills.
A combination of factors suggest now could be the right time to propose ways of boosting investment using changes to capital allowances rules for leasing. They include:
Business uncertainty that means growth in business investment post the pandemic remains slow
The need to boost investment in use of sustainable assets by businesses to meet carbon emissions targets
Potentially more flexibility in policy making post-Brexit, as tax changes don't need to meet stringent European state aid rules
A Chancellor who has recent experience in breaking from conventional approaches to support the economy with the Covid-19 financial support schemes
The core issue with capital allowances is that they only help companies that have taxable profits to offset, so arguably not some of the businesses most needing support when investing.
Growth businesses that are in their early unprofitable years, or more established businesses that are facing difficulties, get no help. As shown in the chart below, over two-thirds of UK companies pay less than £10k corporation tax per year, with another 27% paying between £10k and £50k.
Source: HMRC
To an extent, this can already be solved using leasing. Capital allowances on operating leases (including contract hire) are for the lessor to claim, and in the competitive leasing market this leads to lower rental costs. But for businesses wanting longer term arrangements, often with a transfer of ownership at the end of the lease contract, this doesn't work. If the business needing use of the asset doesn't have taxable profits, the capital allowances can't be claimed, or not until there is tax to be paid.
Annual Investment Allowances
In addition to general capital allowances, since 2018, successive Chancellors have increased and decreased the maximum level of ‘bonus’ first-year capital allowances, called the Annual Investment Allowance (AIA). These bring forward the tax benefits to the first-year assets are acquired, rather than spreading the benefit over (in general) the asset life.
The maximum claimable started at £50k in 2008. It has changed 7 times since then, and stands now at £1m in 2019 (see chart below). There's also a 'bonus' 130% super-deduction capital allowance on qualifying plant and machinery investments that continues until March 2023 (meaning that companies can reduce their tax bills by even more than the cost of their investment).
Annual Investment Allowance limits 2008-2022
Source: HMRC / Asset Finance Policy analysis
Most companies that benefit from the AIA are large and profitable. Even more so than regular capital allowances, they don't help unprofitable companies. Perhaps this is one reason why amounts claimed do not vary hugely with changes to the level of AIA (below).
Source: Office of Tax Simplification / HMRC
Switchable allowances
If capital allowances were ‘switchable’ between lessees and lessors (with or without AIA), the problem of capital allowances only helping profitable companies disappears. An unprofitable business could elect for a (profitable) lessor to claim the allowances and pass back the benefits through lower lease payments.
The US experiment that went wrong
Using leasing to help unprofitable businesses to benefit from tax capital allowances was the goal of a solution tested in the USA under Ronald Reagan. The Economic Recovery Tax Act of 1981 created a federal income tax “safe harbour” for leasing transactions, designed to distribute the US equivalent of capital allowances throughout the corporate sector.
The “safe harbour” in the USA Act in 1981 was an attempt to define the types of leasing transactions for which the lessor could, with confidence, claim tax credits (capital allowances in the UK). The intention was that the bulk of the tax saving would be channelled back to the unprofitable company through reduced rental payments for equipment.
Unfortunately, it was short-lived, being substantially modified by the Tax Equity and Fiscal Responsibility Act of 1982, having been seen as poorly designed, with the mechanism for channelling the benefits to lessees being unclear, and sale and leaseback not being excluded.
Options for pass-through of tax benefits to lessees
Economic theory suggests that the percentage of benefit that will be passed back will be a function of (jointly) the elasticity of demand and elasticity of supply. The stronger the market power of the lessee, and the weaker that of the lessor, the greater the reduction in rental payments.
Leaving it to the market, the pass-back will never be complete. It’s not an ideal arrangement. The US experiment showed the need for an transparent way of ensuring the full pass-back to the lessee of the tax benefits.
That mechanism of pass-through of benefits is more practical than it might first appear, with at least two options, both to be made available for new asset investments using leasing by small and medium-sized companies:
Any lessor can claim capital allowances for any lease (based on accounting definitions). They must provide two rates to the lessee: Before the tax benefit from the allowances, and after the allowances offset by certain costs. The lessor must pay for the pass-through rate to be independently audited (the cost of that audit being an allowable expense).
Government invites tenders for the supply of an interest-free leasing scheme, whereby selected lessors can claim capital allowances on any lease (again, based on accounting definitions) and pass through the allowances in the form of a subsidy to make repayments interest-free for a certain period. In essence, the firms offering the longest interest-free period would win the tender, although there might be different lots for different risk profiles. A procurement model along these lines can be found in the current Bath Clear Air Zone financial assistance scheme.
These are not simple solutions, so we can’t expect them to be implemented overnight. They are very likely to need changes to legislation, to change the tax rules for leasing, and to ensure a fit with the UK’s new regime to regulate subsidies post-Brexit, the Subsidy Control Act 2022.
The Government's consultation seems an ideal opportunity to set out the case for transferable capital allowances for leasing, and there have been similar calls in the USA from a leading tax think tank, the Tax Foundation. Providing we can demonstrate how the tax benefits would be passed through to lessees, everyone wins - lessees, lessors and the wider economy.