HMRC Will Change Finance Lease Taxation In 2006

by Robert Lee, Tax-News.com, London

08 August 2005

The UK's HMRC has confirmed that changes will be made to the way in which some leases of plant and machinery are taxed with effect from 1 April 2006.

Where leases of plant or machinery function essentially as financing transactions the new regime will tax them as such. In particular, the lessor will bring in only the finance element of the rentals arising under the lease as income, and
the lessee will deduct only the finance element of the rentals payable over the life of the lease, and will be entitled to capital allowances.

The reform will apply to finance leases and some operating leases. With the exception of some hire purchase transactions, leases of less than 5 years will not be affected by the reform. The changes will impact cross border leasing as well as domestic leasing.

The proposed changes follow from the Barclay’s Mercantile case decided in the UK House of Lords in 2004. In that case the Inland Revenue sought to prevent capital allowances being available to a UK lessor of a gas pipe line leased to a subsidiary of an Irish group under a sale and lease back transaction. The Inland Revenue failed in their attempt to block the allowances, which they appear to have viewed as a tax subsidy provided at UK expense to a lessee without significant UK tax exposure.

HMRC's hostility to the use of capital allowances by UK lessors in transactions involving a non-UK lessee is reflected in current rules which grant a lower rate of capital allowances where the lessee is not within the UK charge to tax. It is now generally accepted that that rule is contrary to EU law and therefore had to be changed sooner or later.

In his pre-budget statement of 2 December 2004 the UK Chancellor of the Exchequer announced the proposed changes to leasing taxation. Since then draft legislation and technical commentary has been published for consultation; and a further period of consultation is now taking place, closing in October, before the final legislation will be drafted.

Under the proposed new rules, the lessee will receive the capital allowances generated by the expenditure on the equipment, and the lessor will no longer receive such allowances. The leases most likely to be affected by the new regime are long-term big-ticket finance leases and PFI and property leases. Existing leases would be 'grandfathered' into the new regime.

There is controversy over the definition of a 'finance' lease as opposed to an 'operating' lease under the new rules. Various tests are proposed, some of which are different from those conventionally applied to determine accounting treatment. The final test in the proposed tax regime is to consider whether the asset is of such a specialised nature that it would not be reasonable to expect another person to use the asset at the end of the lease term. This will create uncertainty in the leasing market.

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