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HMRC internal manual

Business Leasing Manual

HM Revenue & Customs
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‘Income-into-capital’ schemes and back loaded leases: Definition of a Chapter 2 of Part 21 of CTA 2010 lease: Condition D: whether 'negative depreciation' counts as 'normal rent'

This was relevant to some finance leases existing at 26 November 1996, generating rentals taxable as trading receipts. These existing leases are excluded from Part II of Schedule 12 FA 1997 (now Chapter 3 of Part 21 of CTA 2010) but they sometimes contained subordinate provisions which may cause them to satisfy the other four conditions in Paragraph 3 (now CTA10/S902). Their treatment under the fourth condition is therefore material to whether they come within Part I (now Chapter 2 of Part 21 of CTA 2010) or not.

The issue and our approach is described in detail in paragraphs 17-25 of the article on Schedule 12 (now Part 21 of CTA 2010) published in the April 1997 issue of Tax Bulletin. Paragraphs 24 and 25 in the passage quoted below are particularly noteworthy.

`Definition of lease within Part I-condition in paragraph 3(4) Schedule 12 (now CTA10/S902(7)

  1. What follows under this heading is only relevant for lease rents taxable under Case I of Schedule D.

  2. Paragraph 3(4) is satisfied (and so the lessor will be caught if the other four conditions in paragraph 3 are met) if the taxable measure of the rents from the lease, calculated under the rules apart from Schedule 12 (the ‘normal rent’), is less than the accountancy measure of those earnings (the ‘accountancy rental earnings’).

  3. As stated in our Budget Day Press Release, one reason or the enactment of these provisions was the uncertainty of current law as it applied to lease rentals which were part of trading profits. (There was no dispute in Schedule a [property income] cases: we accepted that the taxable earnings were the rent to which the landlord was ‘entitled’) The Revenue’s contention was that the taxable earnings in trading cases could not be less than the income shown in the commercial accounts where those earnings wholly derived from revenue sources. This view is disputed by the leasing industry and its professional advisers.

  4. We stand by our previous view of Case I leases in applying paragraph 3(4). Thus, we are prepared to accept that paragraph 3(4) is not satisfied (and the lessor escapes Part I) for a period of account if, for any Case I lease, the lessor can demonstrate that:

* the earnings correctly shown in the commercial accounts for that or an earlier period (which in this context may fall before Budget Day) are calculated wholly by reference to rental earnings and not to any extent by reference to any future sum which, in tax terms, is capital; and
* the rentals due under the lease will fully repay the lessor's investment in the lease and also fully pay the lessor's return on investment.
  1. This is on the grounds that, on our view of the existing law in such a case, the ‘accountancy rental earnings’ will not exceed the ‘normal rents’. Hence the lessor will not satisfy the paragraph 3(4) condition and will escape Part I of Schedule 12 (since the Schedule does not apply unless all five conditions in paragraph 3 are met).

  2. By contrast, to the extent that those ‘accountancy rental earnings’ earnings in fact represent a future capital sum, they are themselves capital and cannot be taxed as rental income except under Schedule 12. In that case, the ‘normal rent’ will be correspondingly smaller and the lessor may satisfy paragraph 3(4); if so, the lessor would be caught by Part I of Schedule 12 if the other four conditions in paragraph 3 are met. Whether the ‘normal rent’ represents income or capital is a factual question in each case.

  3. Certainly in cases where the lease provides for a capital sum to be paid to the lessor only in exceptional circumstances (such as if the lessee defaults or the asset is destroyed) we consider that lessors should be able to demonstrate that the possibility of such a sum has not been taken into account in calculating the income shown in the commercial accounts.

  4. The approach set out under this heading is likely to be of particular importance for ‘existing’ Part I leases, as defined in paragraph 27, Schedule 12 (now CTA10/S930). For ‘new’ leases Part II of Schedule 12 will tax as a minimum the ‘accountancy rental earnings’ whether the ‘normal rent’ represents income or capital. This is because only the condition in paragraph 3(1) has to be satisfied before Part II applies: paragraph 16(1) (now CTA10/S927).

  5. The approach set out under this heading is not relevant for Schedule A [property income] lessors because the ) statutory measure of earnings (the ‘entitlement’ basis) is the measure of the ‘normal rent’- not the accountancy measure as we contend under existing law for Case I [trading income]: paragraph 20(b) of Schedule 12”. (Note Paragraph 20(b) was repealed for periods of account beginning on or after 1 April 1998.