Give us a (tax) break!

In life – so the old proverb goes – nothing is certain, except death and taxes. We’re not so sure those are life’s only certainties, but what we are sure of is that there is a definite correlation between the two.

For example, tax an industry heavily and you can be sure that its development will – if not killed – at least be stifled. Conversely, introduce a tax break at the right time, and you can breathe life into a nascent sector.

There are many examples of tax breaks – intentional or otherwise – that have helped to propel incipient businesses.

Take online retailers, like Amazon. Thanks to a 1992 US Supreme Court decision, Amazon was not required to charge customers sales tax on the books it sold as long as it didn’t have a “physical presence” in the customer’s state. Customers were still legally obliged to self-remit the sales tax to their states, but few did.

Needless to say, this gave Amazon a substantial competitive advantage over traditional bricks-and-mortars booksellers and helped it become the online retailer behemoth it is today.

Of course, the yin to this story’s yang is that many cash-strapped US states – led by an inventive 2008 New York law – are now changing the rules and forcing Amazon to collect sales tax. So far it’s only a handful of states, but the list is growing, and will have a quantifiable impact on the company’s bottom line.

That’s a valuable reminder about the fundamental nature of tax breaks: what government giveth, government can one day taketh away.

The IBA debacle

The ‘taketh away’ part is something UK infrastructure investors are painfully familiar with.

Up until 2008, the Industrial Building Allowance (IBA) allowed infrastructure investors to get tax relief on a larger number of the structures and assets they invested in. Specifically, investments in certain structures such as waste facilities and airport terminals received 4 percent in capital allowances.

But in 2007, then-Chancellor Gordon Brown announced that the IBA allowance would be phased out at the rate of 1 percent a year and disappear entirely by April 2011. For Private Finance Initiative (PFI) investors that had factored the IBA into their long-term calculations, abolition came as a major blow.

“Many in the PFI and infrastructure industry saw it as an appalling betrayal,” recalls Tom Lyon, a tax expert at law firm Berwin Leighton Paisner. Ashurst tax partner Nicholas Gardner agrees: “To shift that paradigm halfway though… It was a pretty major change that clawed back cash from some projects that were planned years before the change was announced.”

“Some design-build-finance road schemes had to be renegotiated with the tax authorities,” adds Margaret Stephens, a partner and global head of infrastructure tax at consultancy KPMG.

PFI is the UK’s standardised procurement process for public-private partnerships.

Besides landing some PFI deals in trouble, the abolition of the IBA only served to highlight how fragmented and atavistic the UK tax regime in relation to infrastructure really is. As Lyon neatly summarises it: “The UK is the only G20 country that doesn’t give tax relief for all infrastructure assets.”

According to Lyon, the current tax system implements “an often arcane distinction between things classified as ‘machinery or plant’, which generally attract generous capital allowances and ‘buildings or structures’, which tend not to get tax relief”.

Ashurst’s Gardner also points out that “land and building costs generally don’t get tax relief,” but explains that some projects are based on a different model, allowing some of these costs to be claimed:

“There were historically two models for obtaining tax relief in respect of constructions costs on PFI projects: one was the property business model, where the land was acquired by the PFI operator, which claimed IBAs.”

“The other ‘composite trader model’ was where the PFI operator did not acquire the property as its own capital asset and any design and construction costs are treated as tax deductible revenue expenditure in respect of its trade. The latter model has been unaffected by the abolition of IBAs,” he explains.

But there are still substantial caveats: “Certain projects are unsuitable for the composite trader model. For example, waste recycling or energy generation projects typically involve the PFI operator acquiring and constructing for itself the site on which the project is carried out and therefore do not qualify for composite trader treatment because the site is a fixed capital asset of the PFI operator’s business.”

As UK business lobby the CBI diplomatically encapsulated it in a recent report on how to encourage more private sector infrastructure investment, “the current system of zero tax relief on certain infrastructure assets is a uniquely unattractive feature of the UK tax system”.

The cost of fragmentation

It’s also a costly feature. According to the CBI some £11 billion (€14 billion; $18 billion) or 28 percent of all annual private sector infrastructure investment in the UK “is not eligible for tax relief under the current capital allowances regime, including some transport, energy, water and waste structures”.

The business lobby estimates that “the lack of any tax relief at all makes it around 20 percent more expensive to invest in a structure or building that does not qualify for capital allowances, compared to [one] receiving standard capital allowances”.

The lack of an across-the-board, simplified system of capital allowances for infrastructure investing effectively means the industry is being taxed highly.

“I know a number of infrastructure tax managers who complain that their effective rate of tax on their accounting profit is way above the corporation tax rate. Some infrastructure payments pay an effective tax rate of 30 percent plus,” estimates Gardner.

Stephens also thinks the UK tax system is “very uncompetitive” for infrastructure capital investment, which she estimates can be taxed at more than 40 percent, in some cases.

The obvious impact of all this extra expense is that it hits investors’ rate of return and may place certain types of assets at a competitive disadvantage.

Stephens points out that “you get some utilities building tax into their investment models and being very concerned that if their investments are costlier [because of higher taxes], the regulator will not necessarily allow them to pass on those costs to customers. This can deter investment – in both speed and quantity.”

What makes this discussion particularly relevant now is simple: the Coalition government has put infrastructure investment front and centre in its fight to revive an economy mired in a double-dip recession.

“It could well be that the time is right now,” agrees Adam Renton, associate tax partner, power and utilities, at KPMG. “This government has publicly pledged to reform the tax system to make it more competitive and it also wants to stimulate infrastructure investment.”

The government has, in fact, made much noise around its decade-long, £250 billion infrastructure plans, signalling that it wants the private sector to finance up to two-thirds of it.

There is a strong drive to encourage new sources of funding – like local pension funds and insurance groups – to invest in the asset class and help fund the government’s plans. The PFI framework is under review, with a revised procurement model expected to be unveiled in the autumn.

Put simply, change is in the air, with all the opportunity for good and harm that it naturally carries with it. This means the infrastructure industry is in a privileged position to successfully lobby the government for a more coherent system of capital allowances. After all, the government has been quite vocal about its willingness to court private infrastructure investment.

“It’s generally accepted that to encourage investment [in UK infrastructure] something will be needed [on the tax front],” says Gardner. And there seem to be definite advantages to focusing on a better capital allowances system as opposed to other forms of tax relief.

“I’d focus very heavily on capital allowances [if I were the government],” suggests Berwin Leighton Paisner’s Lyon. “There was a good mechanism in place [the IBA].”

Can the government afford it?

There’s just one small problem: tax breaks cost money, and the UK government is not in a position where it can afford to lose a lot of revenue. That means investors will have to argue their case convincingly, reassuring the Exchequer that a loosening of the purse strings now can go a long way towards fattening it in the not-too-distant future.

Gardner is reluctant to put a figure on how much a new capital allowances scheme might cost the government. But Stephens is convinced that an expansion of the system would be affordable for the government and stressed that the abolition of the IBA didn’t bring in that much money to begin with.

Lyon agrees with her: “As the relief would be spread over many years, the yearly cost to the government could be fairly modest.”

The CBI has attempted to quantify a potential new system via its proposal to extend tax relief to all infrastructure assets not currently covered by the present capital allowances regime, but applying the extended model only to new spending.

“At the outset this would cost an average of up to £200 million (€250 million; $324 million) per year if assets are depreciated over 25 years (4 percent depreciation rate), or an average of up to £130 million per year if assets are depreciated over 40 years (2.5 percent rate),” the CBI estimated in its recent report.

The benefits of an across-the-board system of capital allowances would be threefold, the business lobby argues: it would reduce investment costs; it would make sure investment decisions are not affected by different rates of tax relief; and it would keep the UK competitive in the eyes of foreign investors, which, as the CBI points out, tend to be “highly mobile”.

The cost reductions the CBI alludes to could serve as a compelling investment catalyst.

“Introducing a new capital allowance would reduce the effective cost of investment for the relevant assets by 10 percent (4 percent depreciation rate) or 7 percent (2.5 percent depreciation rate). This would make a material effect on infrastructure investment decisions, with the aim of unlocking new private sector investment in UK infrastructure,” the CBI said.

KPMG’s Stephens supports the CBI’s proposal: “The most effective measure would be to give tax relief to new infrastructure investments. Or reintroduce the IBAs with some tinkering, to allow the inclusion of new types of infrastructure assets.”

Affordability is not the only obstacle investors face, though. Assuming a best-case scenario where the industry gets exactly what it wants, there is still the issue of implementation.

“The government is hopefully looking at [a new capital allowance scheme] at the moment and it would be great if it made an appearance in the pre-budget report that will be published in December,” Gardner says.

“Realistically, though, it is more likely that only a consultation proposal makes it into the December document. In terms of growth, the sooner [there is a new capital allowance scheme] the better, but it will be a challenge to introduce this in the 2013 budget,” he concludes.