FRS12 Accounting for Dilapidations - A Potential Minefield?

5 May 2011

The HMRC are rejecting large numbers of tenants applications under FRS12 on the grounds that the dilapidations provision has not been properly calculated and crucially fails to address the implications of Section 18(1) of the Landlords and tenant act 1927.

Recent publicity has highlighted the opportunity for firms to exclude dilapidations liabilities from their tax computation.

Unfortunately, such publicity has arisen where the assessments concerned have not been carried out in a professional and measurable manner resulting in the HMRC rejecting the assessment. Such publicity emphasises yet again the demonstrable need for corporate good governance on the part of such firms when choosing their advisors.

The following article explains the basic principles for Dilapidations along with the requirements of FRS12 and reinforces the need for the assessment report to be prepared by a dilapidations practitioner.

What are dilapidations?

Dilapidations are breaches of lease covenants to repair. Dilapidations costs are often wrongly anticipated by tenants as insignificant by comparison with rent, rates and service charges. However, repair costs can be significant.

Limiting Dilapidations

The principal form of statutory relief available to the tenant at the end of the lease against a claim for damages is Section 18 (1) of the Landlord & Tenant Act 1927. This statute has two limbs. The first states that the landlord cannot recover damages exceeding the sum by which the landlord's investment has been devalued by the dilapidations. This devaluation is also called the "diminution to the reversion". This may mean that the damages awarded are less than the cost of repairs, even where the disrepair is not disputed. The second limb is potentially an absolute defence; where a tenant proves that a landlord would have, at the end of the lease or shortly thereafter, either demolished the premises or carried out such structural alterations that the disrepair becomes irrelevant. No damages will be recoverable by the landlord in respect of the relevant breaches.

Estimates of dilapidations based upon merely the cost of works are not sufficient to satisfy the HMRC and any assessment must take account of the full range of dilapidations issues.

However,with some careful tax planning, tenants filing accounts under FRS12 could include a firm valuation of current accrued dilapidations liability under the banner of provisions; this assumes the contingent liability (i.e. dilapidations) is material in nature.

A detailed dilapidations assessment by a third party will satisfy the Inland Revenue – and defer the recognition of taxable profit. So even where the dilapidations liability is unavoidable, it can assist the balance sheet if properly managed.

What is FRS12?

The Financial Reporting Standard 12 (FRS12) allows, in certain situations, for a dilapidations liability to be termed an expense which in turn can be included in the profit and loss account of the firm. Accordingly, it will be excluded from the company's tax computation until it is spent.

In order for this to happen, three conditions must occur as follows:-

There is a present obligation from a past event; this usually exists as soon as a lease is entered into.
There must be an “outflow” as a result of the past event. This tends to exist automatically due to the repairing and reinstatement obligations usually contained within leases. These impart a liability on the tenant to either undertake works or to pay damages to the Landlord.
The outflow must be capable of measurement in a reliable manner. Accordingly, a professional, realistic assessment of the tenants' dilapidations liability is required.

If the three key criteria are not met then the dilapidations assessment will be termed a contingent liability and excluded in the tax computation.

The assessment of dilapidations liabilities requires a realistic knowledgeable approach. Fully taking into account all the various facets which need to be considered when producing such an assessment will include:-

The age, nature and locality of the property.
The precise repairing obligations on the part of the tenant.
The likely future market for the property.
Building costs including the affect of the locality and market upon such costs.
The legal obligation to remove and reinstate tenant's alterations.
The various statutory defences available to a tenant during, and at the expiry, of the lease.
The extensive case law which exists in the dilapidations field.

We would recommend that occupiers commission an assessment between 2-3 years before lease end or lease break to allow for the liability to be accrued for.

If you would like to know more please do not hesitate to call Leigh Jeffs on 020 7101 0200 or email him on leigh.jeffs@naihaywards.co.uk

NAI Haywards helps clients optimise their physical assets by taking a holistic and strategic view of their business and property needs. It directs and focuses investment to deliver the best value for the client, positively contributing to their bottom line and giving them a competitive edge.

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FRS12 Accounting for Dilapidations - A Potential Minefield?

The HMRC are rejecting large numbers of tenants applications under FRS12 on the grounds that the dilapidations provision has not been properly calculated and crucially fails to address the implications of Section 18(1) of the Landlords and tenant act 1927.