In recent times, the need by lessors to trigger tax variation clauses on lease agreement contracts has been rare, writes Philip Alton, Partner at Gateley Legal, this may be about to change due to circumstances surrounding the raising of the corporation tax rate to 25% in April.
Announced, revoked, reinstated. No this isn’t a rhyme about Henry VIII’s wives. However, you would be forgiven for being slightly confused when it comes to the current position concerning changes to the rate of corporation tax in the UK.
Since 2008 the UK has seen a gradual reduction in the rate of corporation tax. However, after much back and forth from the Government, this trend now finally seems set to be reversed. From 1 April 2023, the main corporation tax rate will increase from 19% to 25%.
In the past, previous downward changes to corporation tax have tended to have been accompanied by corresponding reductions in the rate of capital allowances. These changes have effectively balanced each other out. Whilst the potential tax benefits of leasing have decreased, very broadly the net return of lessors has remained roughly the same. This has meant that you have to go back quite a long way to find the last time when lessors triggered tax variation clauses.
Clauses of this type allow the lessor to pass any increase in the rate of corporation tax onto their customer in the form of increased rental payments. However, due to the historic balancing act that there has been between corporation tax and capital allowances, in practice there has been no urgent need for lessors to trigger these clauses on UK transactions. However, much like with force majeure clauses during the Covid-19 pandemic, it now may be the time to brush the cobwebs off these tax variation clauses.
On this occasion, the forthcoming increase in corporation tax will see no immediate changes in the rates of capital allowances. So, the familiar balancing act that we have grown accustomed to seems to be coming to an end. Therefore, as it stands, unless lessors react to the change in the pricing of their leases, their after-tax net return may significantly decrease.
Moving forward lessors will want to cover this tax increase in both their existing leases as well as new leases where the terms extend beyond 1 April 2023.
For new leases it will be important for lessors to price the changes in corporation tax into the rentals from inception. This will avoid the need to activate the tax variation clause further down the line – which will simplify matters from both an administrative and accounting point of view.
For existing leases there will be two main considerations for lessors: i) “Do we have a tax variation clause?” and ii) “Should we trigger it?”
Where a particular lease doesn’t contain a tax variation clause there is a possibility that you may have other more generic rights within the agreement that could be used to vary rentals in response to these changes. It would however be worth thinking about incorporating a tax variation clause in future revisions of your lease agreements so as to limit the scope for customer resistance to the use of a variation right which they had not expected to apply to tax risks.
For those who do have a tax variation clause in their lease agreements, you will need to consider whether you wish to trigger this clause. There are clear revenue protection benefits of triggering a variation but these will need to be balanced against legal and commercial considerations. If you decide to trigger a variation you should ensure that the mechanics that you adopt follow the terms set out in the lease so that the variation is validly enforced.
Frequently, these clauses are expressed in terms of the future rentals increasing by a specific percentage for each per cent increase in Corporation Tax. There may also be a requirement for the lessor to give a set or minimum period of notice to the customer of any changes, so it will be important to take into account any relevant notice periods when operating these clauses.
The key point to bear in mind is that a lease is a contract. You should double-check its terms before pressing ahead with any change to the rentals and ensure that your systems will handle the variation in the way that the lease stipulates. If only Henry VIII had operated in this way!
Philip Alton is a partner in the corporate team at Gateley Legal. He has more than 30 years’ experience working across a broad spectrum of finance matters, with particular expertise in equipment leasing and asset finance together with consumer credit work