Use tax relief on retrofits to cut carbon
With the built environment responsible for around 40 per cent of global emissions, it’s an obvious sector for decarbonisation – so why don’t the UK’s tax rules do more to incentivise it, asks fiscal specialist Paul Farey.
The UK has made great strides in attempting to decarbonise its buildings and the construction process through regulation. However, at the same time, the tax system has failed to support owners and occupiers, possibly even incentivising higher-carbon activities by penalising more carbon-friendly approaches. The only ‘green’ relief of note on the UK statute now is the 150 per cent deduction for the remediation of contaminated land[i], encouraging development of brownfield sites.
In withdrawing Enhanced Capital Allowances (ECA) in March 2020, the government removed a 100 per cent tax deduction for investing in new energy and water-saving technologies. The ECA regime was imperfect but did arguably encourage developers to actively consider carbon-efficient measures.
Recent changes to the capital allowances legislation[ii] for non-residential properties have provided additional and accelerated relief for taxpayers’ capital expenditure through the Structures and Buildings Allowance[iii] (SBA), increased Annual Investment Allowance[iv] (AIA), together with the temporary super-deduction and special rate allowance[v] (temporary FYA). Whilst these measures have been warmly welcomed by taxpayers, they are agnostic in terms of carbon. The AIA and temporary FYA are both aimed at plant and machinery and arguably promote investment in mechanical and electrical installations, rather than passive and lower-carbon construction technologies. In terms of these construction technologies, only external solar shading and thermal insulation can be considered as plant; the latter only where it is installed in existing buildings.
When considering Value Added Tax (VAT), the position is even more counter-intuitive. New-build residential development is ordinarily zero rated for VAT, whereas refurbishment and alterations are generally standard rated. The preferred route to net zero carbon is to work with existing buildings, repurposing where possible: demolition and reconstruction are highly carbon intensive processes. Surprisingly, the VAT rules effectively incentivise developers to demolish existing buildings to secure the zero rate, rather than refurbishing existing stock; an approach that seems incongruous with the stated aim of the government. Whilst a reduced VAT rate of 5 per cent does apply for selected alteration activities[vi], the exempt nature of property transactions can ultimately result in additional costs of up to 20 per cent, where VAT paid cannot be recovered.
Global events have clearly sidelined many plans, including what the government can afford to do, but a broader overhaul of the fiscal rules is necessary and should strive to be neutral. Tax relief for ‘greener’ buildings ought to be balanced through the taxation of poorer carbon- performing assets – much like we have seen with the government’s recent approach to building safety, introducing the Residential Property Developer Tax as a time-limited measure to recoup the costs of cladding remediation provided under the Building Safety Fund.
However, measurement is critical to any such approach; base data for carbon must be consistent, well-defined, easily measurable and readily accessible in order to determine relativity and gauge improvements in performance. Existing measures, such as EPC ratings, focus on theoretical energy consumption, which, whilst they can be converted to operational carbon, are not yet sophisticated enough to assess the carbon embedded in the construction process.
Therefore, while they can operate as an acceptable measure of improvement (‘before’ versus ‘after’) they are not necessarily sufficiently thorough to assess the improvements required to achieve net zero carbon targets. Two step changes are needed:
- A more detailed quantitative approach, focused on measuring actual operational energy, through established platforms such as NABERS[vii] and;
- Incorporating key base-building embodied carbon data.
The combined measure would ultimately provide a robust and reliable springboard upon which to develop a more balanced system of both taxation and incentive around carbon. In the short-term, there are some relatively easy wins; measures that could help incentivise taxpayers’ positive behaviours towards net carbon zero through the mitigation of their initial capital spend. Our thoughts include the following:
- Extending the zero rate for VAT to refurbishments of residential property, as a means of disincentivising the unnecessary demolition and redevelopment of existing stock.
- The reduced rate of VAT for energy-saving materials should be extended from residential to all property (including commercial). Whilst most commercial VAT is recoverable, there are circumstances where VAT-exempt parties will benefit from the reduction.
- A temporary increase to land remediation relief from 150 per cent to 200 per cent for five years; this will further encourage developers to tackle brownfield sites in cities and legacy industrial areas. The payable credit for lossmaking companies should also be proportionately increased.
- Broadening the definition of plant and machinery for capital allowances to include passive construction measures that reduce carbon; such as including insulation for new-build properties, rainwater capture and recycling, green roofs etc. Capital expenditure on such assets should be allocated to a new ‘green’ pool attracting a permanent enhanced allowance of at least 100 per cent.
- The ‘green’ pool could also include readily identifiable low-carbon mechanical and electrical assets such as LED lighting, ground and air-source heat pumps, low-liquid toilets, leak detection, intelligent control systems and other defined technologies. This would avoid the historic ECA challenges of reviewing technology, manufacturer and model-specific lists that are time sensitive.
- Removal of the CAA2001, s.33B restriction of ‘replacement’ for integral features, to allow the expenditure for repairs to be fully expensed for tax purposes. At present, repairs to integral features are treated as capital where the spend exceeds half the cost of replacement of the asset in any 12-month period, restricting the cash benefit.
- Capital allowances for the demolition of plant and machinery[viii] should be withdrawn, unless the assets are replaced within (say) a 12-month period and the overall building is not demolished.
- Accelerated SBA for expenditure on green buildings through current established measures, such as EPC ‘A’ ratings, BREEAM ‘Outstanding’ or LEED ‘Platinum’. In addition, the SBA could also be accelerated for refurbishment projects to disincentivise demolition; as well as tackling vacant premises, along the lines of the Business Premises Renovation Allowance[xi]. New-build construction would retain the existing longer-term rates.
- A dedicated R&D tax credit/enhanced deduction for operational costs associated with decarbonisation activities to existing properties and estates.
UK taxation is systematic and has the ability to proactively support taxpayers on the path to net zero carbon in terms of the built environment. The challenges are complex and a broad suite of tools – both in terms of carrot and stick – will be necessary. Whilst there appears to be a roadmap around the latter, the former still needs some work.
An edited version of this article first appeared in Property Week.
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[i] Land remediation relief under Corporation Tax Act 2009, Part 14.
[ii] Capital Allowances Act 2001 (CAA2001)
[iii] Introduced under FA2019, allowing the construction costs of non-residential buildings and structures to be written -off at 3% annually over a 33⅓ years on a straight-line basis.
[iv] Annual Investment Allowance allows the first £1M of capital expenditure incurred by a taxpayer on new plant and machinery assets to be deducted in full in the year of spend. The AIA reduces to £200K from 1 April 2023.
[v] Enhanced capital allowances providing 130% deduction/50% first year allowances (FYA) for investment in new plant and machinery assets.
[vi] The 5% reduced VAT rate applies for works such as converting commercial property to residential; refurbishing residential property that has been vacant for at least two years; or altering the number of dwellings within a residential property.
[vii] NABERS allows owners of office buildings to benchmark energy use corrected for area (NIA) in use, and hours. Ratings for office tenancies and office whole buildings are also currently under development for the UK. (In Australia NABERS also rates hotels, shopping centres, data centres, apartment common areas, aged care and schools).
[viii] Section 26, CAA2001.
[ix] Business Premises Renovation Allowance (BPRA) – a 100% relief for capital expenditure incurred bringing vacant property back into use within nominated disadvantaged areas. BPRA were withdrawn in 2017.