BN 14: Taxation of Leased Plant and Machinery

Who is likely to be affected?

1. Lessors and some lessees of plant or machinery where the lease is essentially a financing transaction. Leases of less than 5 years, and in some cases 7 years or more, will not be affected.

General description of the measure

2. This legislation aligns the tax treatment of leased plant and machinery with that of plant and machinery acquired with other forms of finance. As a consequence it reduces a distortion in the current system caused by the differing tax treatment of finance from different sources.

3. Subject to an option to elect otherwise, this legislation will only apply to longer leases that are essentially financing transactions. These leases will be known as “long funding leases”.

Operative date

4. In general, the legislation will apply to long funding leases finalised on or after 1 April 2006. Transitional arrangements will allow some leases finalised on or after this date to remain unaffected by the new rules.

Current law and proposed revisions

5. Under the current law:

• lessors of plant and machinery are entitled to claim capital allowances on its cost and they are taxed on all the rentals received from the lessees; and
• lessees are not entitled to capital allowances and are entitled to a deduction for all their rentals.

6. Some leases function in a very similar way to a loan. Where this is the case, the new regime will:

• prevent lessors claiming capital allowances on the cost of the leased asset and tax them only on the proportion of the rental income that reflects the financing charges; and
• allow lessees to claim capital allowances on much the same amount as they would have been able to had they bought the asset, and receive a deduction for that part of the rentals on which capital allowances are not available.

7. Subject to anti-avoidance rules, the new regime will not apply to:

• leases of less than 5 years; or
• leases of between 5 and 7 years where certain conditions are met.

Tonnage tax

8. The new regime will not apply to leases that would otherwise be long funding leases of ships to companies within tonnage tax as long as the lease is directly to the tonnage tax company or indirectly via one member of the tonnage tax company’s group.

9. In order to meet this condition, where the lease contract is finalised on or after 1 April 2006, the tonnage tax company will also be required:

• to operate and manage the ship; and
• not to lease the ship out for more than 7 years at a time.

10. A company will be regarded as operating and managing the ship where it is responsible for operating the ship throughout the period of the charter and for defraying all or substantially all expenses in connection with the ship during that period.

Transitional rules

11. Details of the transitional arrangements were contained in the draft legislation published on 5 December 2005. The principle conditions that must be met before the transitional rules apply are that there was an agreement to lease the plant or machinery (referred to as "pre-existing heads of agreement" in that draft legislation) in place before 21 July 2005 and that the asset is under construction before 1 April 2006.

12. Amendments will be made to the draft legislation to ensure that:

• all leases of plant or machinery finalised (made unconditional with no terms to be agreed) before 21 July 2005 remain taxed on the basis of the current law, i.e. they will remain within the existing regime; and
• where a lease does not remain within the existing regime, expenditure incurred before Royal Assent to Finance Bill 2006 will be subject to the existing regime only where there was an agreement to lease the plant or machinery in place before 21 July 2005.

13. In those cases where a lease does not remain within the existing regime, our view is that if a contract for the provision of the leased plant or machinery is varied so that expenditure to be incurred by a lessor is brought forward so that additional sums are payable before Royal Assent, those additional payments fall within the new regime. However, to avoid doubt, an explicit provision to this effect will be included in the final legislation. This specific provision will not apply where the variation took place, or the lease was finalised, before 22 March.

Election

14. The legislation will give HM Treasury the power to make regulations that will allow lessors to elect for leases, other than leases of cars, to be taxed under the new regime providing that the value of the leased assets does not exceed £10m. The election will not need to be made on a group basis and will be available to any lessor.

15. The election will be available for leases finalised on or after 1 April 2006, but only where the asset has not been leased before or has been previously leased only under a long funding lease.

16. An election should allow lessors to be taxed on the leasing profits shown in their accounts providing those accounts reflect the profits that would be taxed on the statutory basis.

Other changes

First year allowances

17. To ensure stability of the new regime, the legislation will make amendments that will allow first year allowances to remain available to lessors only where:

• they lease cars with low carbon dioxide emissions; or
• the plant or machinery is leased with a building and functions as background plant or machinery.

Hire purchase

18. The legislation will amend the hire purchase rules in section 67 Capital Allowances Act 2001 so that:

• hire purchase transactions with overseas lessees are treated in the same way as transaction with UK lessees;
• they only apply to a lessee if the lease should be accounted for as a finance lease under generally accepted accounting principles; and
• the hire purchase rules will apply equally to alternative hire purchase arrangements, for example those developed to be Shari’a compliant.

19. The changes to the hire purchase rules will apply to contracts finalised on or after 1 April 2006.

Finance costs

20. The legislation will make two changes that apply to companies carrying on oil extraction activities etc. in the UK or on the UK continental shelf. It will:

• expand the scope of s.494AA ICTA, which deals with the finance costs arising on sale and leaseback transactions, to cover sale and leaseback transactions where the leaseback is what the legislation refers to as a "long funding operating lease" of plant or machinery; and
• amend the definition of “finance costs” in s.501A ICTA which is used in calculating the adjusted ring fence profits on which the supplementary charge is payable.

21. A similar change will be made to the definition of finance costs in paragraph 63 of Schedule 22 Finance Act 2000, which governs the way that finance costs are to be allocated between tonnage tax and nontonnage tax activities.

Further advice

22. Further draft legislation and a Technical Note will be published before the end of March 2006.

23. A final Regulatory Impact Assessment is available on the HM Revenue &
Customs website.

24. If you have any questions about this change, please contact Paul Lane on 020 7147 2637 email Paul Lane or Malcolm Smith on 020 7147 2555. Information about Budget measures is now available.

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