Dilapidations accounting

The vast majority of modern commercial leases are clear in their contractual requirements for tenants and lessees to maintain the property in a good condition, along with the need for them to redecorate, remove any additions they have made to the property, or reinstall any parts of the property they may have removed, when the lease comes to an end.

The finer details of how such repairs and redecorations – known as dilapidations – need to be made will differ from lease to lease, but what is important across all contracts is the need to plan for the costs of such work during the time of the lease, rather than waiting until the lease ends and then facing a potential significant charge or claim from the landlord.

Dilapidations planning has both financial and business benefits. While not all dilapidations are treated as tax deductible (see below), many are, and provision that is made for those dilapidations during the term of the lease can help to reduce tax bills throughout the course of the lease, rather than solely at the point the work is done (often at the end of the lease).

Businesses that fail to make provision for dilapidations during the life of a lease can also find themselves facing an unplanned sizeable bill at the point when the lease ends. In some cases, when this bill runs into six or even seven figures, businesses can find themselves ‘trapped’ in a property, having to operate from premises that aren’t fit for purpose or best suited to the future growth of the business, because they can’t afford the one-off cost of the dilapidations.

Remember Accounting Standards require a business to recognise a provision in its financial statements when it has an obligation at the reporting date; arising from a past event; where the settlement of which will probably give rise to a transfer of economic value and; that transfer of economic value can be estimated reliably.

Tax implications

In most cases the obligations under a lease arise from the date the lease is signed so tenants can make a provision for dilapidations within their annual profit and loss accounts, in anticipation of the cost of future repairs and renovations that will need to be made in line with their lease obligations. Such provisions, provided they meet certain requirements, may well be tax deductible, and deductions can be claimed at the time the provision is made, rather than at the point when the dilapidations work is carried out.

The provision will be tax deductible if it relates to specific repairs or works, and those works aren’t considered to be capital expenditure. HMRC gives examples of what would be regarded as capital works, including:

• the cost of rebuilding the leased premises
• the cost of reinstating any part of the leased premises demolished by the tenant
• the cost of demolishing any structure which the tenant has added.

The proportion of a specific provision made for works that are regarded as capital in nature will not be deductible for tax purposes; however, when a lease ends and that capital expenditure is made, some of it may qualify under capital allowances.

A full tax deduction can be taken for the remainder of the provision, as and when that provision is made. Once again, there are criteria for the provision to be tax deductible, so it is important to seek expert financial advice at an early stage of dilapidation account planning. It’s also important to seek the advice of a chartered surveyor, to get an accurate assessment of the future dilapidations that a tenant could face, so that adequate provision can be made in the annual accounts.

Lease end adjustments

When the repair and reinstatement works are carried out at the end of a lease, and the final costs are known, it may materialise that the tenant has either under-estimated or over-estimated the costs of the dilapidations, and an adjustment will be needed. If the accounting provision turns out to be in excess of the dilapidations expenditure, the difference is added back to the taxable income and taxed in the year of the works. If the provision is less than is needed, any additional actual expenditure can be deducted within the year the work is completed.

Dilapidations accounting is a potentially complex area, and one which can have major implications for a tenant or commercial property lessee. But the key message is that with careful planning, making provision for dilapidations can bring significant benefits, both in terms of accounting and business development.

This post was written by Richard Vass. For more information or to ask Richard a question fill in the form below.