Cash Accounting for Landlords : A detailed review
A quick look at some of the key findings of a reasonably deep dive into the legislation for the new cash basis for landlords: don’t do it!
A Happy New Year to TW readers and my thoughts are with practitioners who toil through the Self Assessment January trials.
Last year, Bloomsbury asked me to update some of my chapters in the Buy To Let Property Tax Handbook for their online reference library. To do so, I had to contend with:
- Making Tax Digital (and regular readers will already have a good sense of how much I love that regime), and
- The Cash Basis for Landlords
Suffice it to say that the more I read into these areas, the less I liked them. This article looks at the new cash basis for landlords, and a follow-up article will look at Making Tax Digital. Much of the article borrows / summarises the Bloomsbury updates, and I am grateful for Bloomsbury’s kind permission to re-use some of the content of the BTL book herein.
Essential – Why Has the Cash Basis Been Introduced for Landlords?
Readers need to be aware that the cash basis for landlords (“the cash basis”) has NOT been introduced to simplify matters for landlords or for their agents. It has been introduced to simplify matters for HMRC. Nor will it save landlords any money – anyone who is at least passingly familiar with how rental businesses typically operate would see that this is highly unlikely.
Indeed, the legislation has been carefully constructed to ensure that the Exchequer will not lose out from the “simplifications”, with the end result that, at the margins, this new regime is pretty much as complex as the one HMRC hopes it will replace.
Essential – Cash Basis ON by Default – You Need to ELECT OUT
The legislation underpinning the cash basis, at F(No 2)A 2017 Sch 2 Pt 2, was introduced several months after it was deemed to apply. Where it could apply, the cash basis did so automatically from 6 April 2017 – i.e., for the 2017/18 tax year for which returns are still being prepared. It is necessary to elect out of the cash basis, and to do so on a continuing basis. Having reviewed the cash basis for landlords now in some detail, I find very little to recommend it and have instead been recommending to all of my taxpayer and professional clients that it be eschewed by default.
Cash Basis v Accruals Basis
Most professional advisers will be comfortable with the distinction between the standard “traditional” accruals accounting basis and the new cash accounting basis:
- The accruals basis seeks to recognise the income ‘earned’ in a period, regardless of when payment is received, and to deduct the cost of generating that income, without worrying about when the business actually makes payment
- The cash basis concentrates only on cash received and cash paid out, in a given period
This means that a tenant who pays late – after the end of the period – will be ignored under the cash basis but not under the accruals basis; while amounts owed but unpaid to other parties will usually be recognised under the accruals basis but not under the cash basis.
In theory, the cash basis should be more straight forward. Thanks to the draftsman’s efforts to ensure that the cash basis does not cost the Exchequer any tax revenue, it is not.
To What Rental Businesses Will HMRC Apply the Cash Basis by Default?
Although the legislation’s approach is slightly different, it would be easier to say that the cash basis is in point unless one of a number of exclusions applies, including where:
(1) The business is carried on at any time in the tax year by any of:
(a) a company;
(b) a limited liability partnership, (which is, legally, a body corporate);
(c) any other partnership, where any partner is not an individual; or
(d) the trustees of a trust.
(2) The annual gross receipts in the year (calculated under the assumption that the cash basis applies) exceed £150,000, as adjusted if the business is carried on for only part of the year.
(3) There would be a balancing event under the Business Premises Renovation Allowance in the year, if Generally Accepted Accounting Principles (GAAP) were adopted.
(4) Where at least part of the property letting business is carried on jointly with a spouse or civil partner, that spouse or civil partner has adopted GAAP in their own tax return (but see below).
(5) Where the landlord elects out of the cash basis, within one year of the normal self-assessment filing date for the year in question.
Complexity – Property Partnerships, Etc.
Different property businesses – partnerships, etc., - are evaluated separately. Tax professionals may want to keep an eye on whether or not a joint property business is merely a co-owned joint investment activity, (as HMRC much prefers), or a partnership. In particular, note that where a partnership does exist, its ‘eligibility’ is assessed at the partnership level, not at the individual investor level. Joint investment with a corporate co-owner would not prevent the cash basis’ applying to the individual co-owner in the way that it would if they were in partnership.
Complexity – Spouses and Civil Partners
Many readers will have heard that spouses or civil partners have to apply the same basis, so if one spouse chooses to adopt the accruals basis, then so must the other. Unfortunately, this is inaccurate. So too is HMRC’s own guidance at PIM1092. What the legislation actually says at Condition C of the new ITTOIA 2005 s271A is that the cash basis is disapplied ONLY if the other spouse adopts GAAP AND to the extent that their joint income is deemed to be split equally in accordance with ITA 2007 s 836. It is nonsense to suggest, as per PIM1092, that an election is necessary under s 837 to apportion according to the underlying beneficial ownership. While a s 837 election may act to disapply the presumption of equal income interests, what about partnership property income, or Furnished Holiday Accommodation?
Complexity – Capital Expenditure
Simply put, the cash basis applies to capital expenditure except where it does not. Over several pages, the legislation works hard to ensure that the legislation is as permissive as possible, without actually giving anything away. For example, land and buildings themselves remain subject to Capital Gains Tax. Capital Allowances are excluded, except for cars (CAA 2001 s 1A(1)–(5)) and Replacement Domestic Items Relief, basically for residential property. A kind of “Annual Investment Allowance Lite” applies to ‘depreciating assets’ as defined in the new legislation – which is different from (and much stricter than) that with which most practitioners will be familiar under TCGA 1992 s 154.
Complexity – Transition To / From the Cash Basis
Bearing in mind that, in the absence of an election to the contrary, very many landlords will have unwittingly transitioned to the cash basis almost two years ago, the actual mechanism of transition – and transition back – is not necessarily straight forward and can be quite involved. Adjustments may be required for Capital Allowances, unspent finance and hire purchase arrangements, and for private use of capital items, which can trigger a deemed disposal and corresponding Income Tax charge. Similar provisions apply if the business wants or is forced to transition back to the accruals/GAAP basis.
Summary of Hidden Complexities and Penalties for Adopting the Cash Basis
- Rent is generally paid at least a month in advance, and often more than that. The cash basis is therefore likely to recognise income paid earlier than it would be under the accruals basis, which would treat rental income paid towards the end of the year (but actually in respect of the following year) as a prepayment – i.e., it would be discounted, or excluded.
- Where rent is due but outstanding, an accountant drawing up accounts according to the more traditional accruals basis would normally check to see if it should be discounted or provided for as a ‘bad debt’ – effectively negating much of the claimed benefit of the cash basis in terms of recognising rental income only when actually received.
- Likewise where the accruals basis requires expenses to be discounted or ‘accrued for’ (in reality it is only the first year of incurring that expense in which this adjustment will have any impact: in the second and subsequent years of an accrued expense, the part discounted or excluded in one year should automatically be included as a cost attributable to the earlier part of the following year, effectively putting the accruals basis on an even footing with the cash basis (unless those accrued expenses tend to rise significantly from one year to the next, in which case a difference may ‘linger’). If a rental business is profitable, the potential saving here is more than likely outweighed by the cost of recognising ‘early’ rental receipts.
- If an item of capital expenditure is allowable under the cash basis, any proceeds on disposal will almost certainly be treated as property income, even if it would ordinarily be considered a capital gain under the normal rules. Although most common appreciating asset classes will remain outside the cash basis and continue to be subject to CGT, if a cash basis item is disposed of for a gain, it will not benefit from the CGT Annual Exemption, but will be subject to Income Tax at potentially significantly higher rates than under CGT.
- The restriction of Capital Allowances and agricultural expenses in terms of the forfeiture of sideways loss relief will potentially put eligible landlords at a significant disadvantage if they adopt the cash basis. Typically, landlords with commercial property will be eligible for significant Capital Allowances claims, and especially when buying commercial property that could be eligible for a substantial initial claim, that could in turn result in a net loss in the business (although this must be considered in light of the overall annual gross income limit for the cash basis).
- In theory, obtaining immediate relief for capital expenditure will be advantageous. However, the legislation for the cash basis narrows the scope for relief for capital expenditure to the extent that it aligns closely to that which would be eligible for immediate relief already, under either the AIA category of Capital Allowances, or Replacement of Domestic Items Relief.
- Likewise, immediate relief for any residual pool of unclaimed Capital Allowances on joining the cash basis might be beneficial, but most landlords coming within the scope of the cash basis will have benefitted from the AIA over the last few years to the extent that any Tax Written Down Value brought forward in the pool (ignoring cars, which will not move to the cash basis anyway) will be small (or, if less than £1,000, should have been written off already under the small pool allowance (CAA 2001 s 56A)).
- Also, it seems that any capital items which are first brought into use some time after they were acquired will not be able to access relief under the cash basis (other than could perhaps be argued in the context of ‘pre-trading expenses’, as expressly allowed under ITTOIA 2005 s 272ZA). Under the Capital Allowances regime (such as it applies more widely under the GAAP/accruals basis), there are provisions to allow relief where an asset has been bought some time beforehand and is only later used for a qualifying purpose, (such as where first used privately, or for another qualifying purpose), or the business has neglected to make a claim until it is out of time to claim for the year of acquisition. There appear to be no corresponding provisions under the cash basis.
Amongst other things, this mean that landlords could permanently lose any entitlement to relief on otherwise-eligible assets not already allocated to a capital allowances pool if they allow themselves to be transitioned to the cash basis in 2017/18.
- The treatment of assets which cease to be in use, or start to be used less for business purposes (or more for private purposes) is potentially quite inequitable as it deems a charge to Income Tax to arise, but there seems to be no provision for redress if use in the property business subsequently increases or resumes.
- In fact, many landlords may face an effective charge for joining the cash basis. For example, where assets have had Capital Allowances claimed on them and are also subject to payment by instalment arrangements at the point of adopting the cash basis, (typically under hire-purchase or similar), the payments to date must equate to the Capital Allowances claimed and, while any shortfall in Capital Allowances would result in a further expense deemed to arise in the year of adopting the cash basis, it is far more likely that 100% AIA will have been claimed on the asset’s purchase, so that some of that previous claim will be clawed back on transition.
- The restriction on relief for lease premium payments could be a significant real cost of adopting the cash basis. Lease premia sometimes arise with flats and apartments, but more so with commercial properties, in a ‘seller’s market’.
- The vaunted simplicity of the cash basis is clearly questionable, given the volume and the complexity of the legislation governing its use. For example, a landlord will still need to consider whether or not an item of expenditure is capital or revenue in nature, thereby to determine if, as a capital item, it is then subject to one of the numerous restrictions on relief for capital items of expenditure (such as expenditure on land or buildings, and some fixtures).
- Likewise where there are claims for finance costs, landlords will still have effectively to monitor:
– a notional capital account with their business to make sure that, in effect, they are not ‘overdrawn’, albeit by a using a slightly different approach; and
– any capital expenditure not otherwise allowed under the cash basis that will supplement the ‘allowable cost’ of the assets introduced to the property business for the purposes of determining the extent of interest, etc, that may be deducted
- Where the difference between the accruals basis and the cash basis is significant, then it may well mean that the technical adjustments potentially required for moving from one basis to the other (for instance, by default in 2017/18) actually make it more straightforward to continue with the status quo.
- The rules governing partnership property businesses and the new cash basis, and spouses and civil partners, are complex, and HMRC guidance does not cover the finer points in detail.
- While the annual gross income limit of £150,000 is not insubstantial, this will be well within the scope or ambition of many career landlords; the complex rules governing transition to and from the regime might again make the cash basis a burden best avoided – particularly in cases where there is a risk of annual incomes fluctuating above and below the gross receipts threshold.
Why Was This Inflicted On Us?
It could be argued that the real motive behind ‘simplifying’ the tax reporting regime is actually in how it will become much easier for HMRC to check landlords’ tax returns. HMRC has powers to require letting agents to provide financial data on each and every property they manage, for each and every landlord for whom they act.
HMRC is not exactly sparing in its use of these ‘bulk data powers’ (FA 2011 Sch 23). Letting agents effectively adopt the cash basis when supplying such data to HMRC, so encouraging landlords also to adopt the cash basis (such as by making them adopt the cash basis unless they deliberately elect out) should mean that there is a strong correlation between the information on a landlord’s tax return and that which has been supplied by the landlord’s letting agent(s).
HMRC’s intention seems to be that, in future, those landlords who have so far escaped quarterly reporting under Making Tax Digital will nevertheless start to see the Land and Property pages of their tax returns pre-populated with the information provided to HMRC by the landlord’s letting agent(s). This functionality will be automated by HMRC’s own software, utilising those common reporting standards. HMRC’s hope is that this approach will ensure that all income will be captured and it will then fall to the landlord to identify and to claim any additional expenses that they have incurred directly – i.e., over and above any reported by the letting agent as being laid out on the landlord’s behalf (mortgage interest being an obvious example, as it is usually paid directly by the landlord rather than by the letting agent).
This approach should ensure that the majority of rental income is returned automatically (save for where letting agents are not involved); as a consequence, the risk is then borne predominantly by the landlord, to ensure that all expenses are claimed. To put it another way, the risk is that ‘simplicity’ will mean landlords simply accepting HMRC’s figures, and not claiming all of the additional expenses to which they might be entitled; likewise that HM Inspectors will not have to concern themselves overmuch with the complexities of accounting adjustments, when enquiring into landlords’ tax returns.
After more than twenty years of working in tax, I suspect I am not along in having developed a nervous tic that manifests itself whenever I read or hear HMRC use the word “simplification”. Only the smallest of rental businesses might find the new cash basis straight forward – and they would probably not have suffered to any appreciable extent at the hands of the accruals basis in the first place. When this new cash basis was formally announced in January 2017, the accompanying Tax Impact and Information Notice claimed that it would benefit as many as 1.8 million property businesses. That is patent, blatant, cobblers, and serves only to remind me of just how sceptical one should be when approaching TIINs.
by Lee Sharpe