The judgement in a recent case (Gunfleet Sands Ltd and others v HMRC [2022] UKFTT 35 (TC)), concerning the costs of evaluation and design of a potential windfarm development, provides some current judicial thinking on what costs may qualify for plant and machinery capital allowances (PMAs).  

For large capital intensive projects such as oil and gas projects, as well as alternative energy projects, the entitlement to tax relief for the costs of project scoping, planning, and evaluation has been an area of doubt for many years, and taxpayers have had to rely on interpretations that have not been tested in court. This windfarm case addresses such costs head on and concludes that relief under the plant and machinery code is wider than perhaps had been previously thought.

Any evaluation of the tax relief for capital intensive projects in the energy sector is likely to be affected by the lessons from this case. Although the decision may be beneficial in some cases, it may also adversely affect the relief available in the oil and gas industry, particularly as an application of the current decision may result in companies no longer being able to claim mineral extraction allowances on certain costs.

Unfortunately, a number of the difficult questions which arise where upfront planning costs are concerned did not need to be addressed in this decision as costs were incurred when the company was not yet trading, and allowances were only considered once the taxpayer had commenced a trade and at that stage most of the assets to which the planning and design costs related had been installed.

Background

The case has had a long gestation period, with the claims to capital allowances dating back to 2009. The result goes against HMRC’s current interpretation of the law on a number of points. This is, however, a First Tier Tribunal (FTT) case and as such has no precedent value and indeed an appeal has been scheduled for hearing in June next year. . There were nevertheless some useful analyses which may be helpful in deciding whether similar costs on other long-term projects are claimable.

The expenditure

Plant and machinery capital allowances were claimed in respect of various different types of expenditure incurred in establishing an offshore wind farm array, consisting of the generating units (turbines mounted on the seabed) and the electrical cables (“array cables”) etc. from those units to a substation. The units and the array cables comprised “the generation assets”.

The dispute concerned, inter alia, the availability of plant and machinery allowances (PMAs) on “design” expenditure.

This design expenditure included environmental impact studies, studies of the sea conditions (metocean studies), geophysical studies of the seabed, and project management costs.

The claims to the disputed qualifying expenditure were made on the commencement of trade, meaning that expenditure incurred years before was only claimed at the time that much of the physical equipment was in place. This in turn meant that there was no need to address the application of the abortive expenditure rules in the plant and machinery code and, in particular, the issue of whether a claim for study costs could be made in a case where no plant was ever acquired or installed. 

The arguments in brief

HMRC argued that the generating units and electrical equipment were separate plant and machinery assets. In their view the expenditure on the studies was too remote to be counted as ‘on the provision’ of any of these separate items of plant and machinery as finally installed, as much of it was carried out to meet regulatory requirements on the impact of siting plant and machinery in specific locations.

In contrast, the companies argued that the whole windfarm array “the generation asset” was a single asset of plant (or machinery), and that the studies were incurred on providing that plant; choosing its configuration and installing it in accordance with all the regulatory requirements for environmental/shipping /wildlife impact assessments were all necessary to the provision.

The judgment – key elements

One asset, or many?

As in all capital allowance claims for plant and machinery, the asset must be identified. The identification of the plant can have an important effect. In this case, for example, the array might be seen to have a different function to a single installed turbine generator.

The judgment rejected HMRC’s contention that the individual elements constituted the relevant plant and machinery assets and held that the “generation asset”– the array – was the asset.

This determination will always be a question of fact which will need to be looked at on a case by case basis but the judgement offers some useful guidance on what will be relevant in any such decision.  Here, each generation asset was designed, manufactured and installed to operate as a single electricity generating unit and collectively were directed to a single purpose of generating electricity.

Studies and design – “On the provision of plant and machinery” or too remote?

HMRC argued that case law showed that “on the provision of” is tightly drawn and only extends beyond the price actually paid for the plant, to costs such as transportation, installation, and construction of the plant in question.

Additionally, HMRC argued that expenditure can be too remote if it has been incurred at a time when the identity of the plant to which it relates is not known.

HMRC further argued that the costs incurred on the surveys put the appellants in the position to know what plant and machinery to purchase, but those costs were not incurred on the provision of that plant.

The judgement sets out that the test to apply is whether the costs are needed to effect the actual provision or supply of the plant, together with the costs that must be incurred to make it usable at its basic level. Expenditure on the provision does not however include expenditure which is necessary or desirable to optimise the use of the plant.  The FTT cited the Barclay Curle dry dock case as precedent for determining this as the correct test.  That case also found that all expenditure which must be incurred before plant can be put in place to enable it to properly function should be regarded as expenditure on the provision of plant. The FTT correlated the term “must” with the word “necessary”.

In testing whether expenditure is necessary the FTT stated that this needs to be tested against the function or purpose for which the plant is designed.

In the case of the windfarms: they were designed to generate electricity. That generation function is carried out by the generation assets. These include the individual wind turbines which convert the kinetic wind energy into electrical energy. That electricity is then conducted to the substation by the array cables.

So, expenditure on design without which the windfarms or wind turbines could not carry out those functions, and without which the windfarms or wind turbines would be operationally useless, falls into the “must” or “necessary” category of design. It cannot be too remote.

Such “necessary” design qualifies as expenditure on the provision of plant whereas unnecessary design, would not. Furthermore, studies to choose the location of the entire array were excluded from qualifying as these did not determine the design, construction or installation of the array as installed.

It was held that much of the expenditure on studies was on the provision of the plant and machinery as finally acquired, despite having been incurred prior to the decision being made on which physical equipment would be acquired.  This earlier expenditure was still “on the provision of” the plant acquired, as it was essentially part of the necessary design work including the ‘design’ of the installation work.

The test was to be applied by reference to the effect of the expenditure (on design and installation), and not its purpose. The FTT judge further commented that any duality of purpose (such as the ‘purpose’ of meeting regulatory requirements) should not affect the decision.

The FTT considered each of the various studies separately, with some being held to qualify and others not. The fish and shellfish study costs were allowed to the extent the studies dictated the necessary installation techniques (minimising disruption to the fish). The detailed metocean studies were allowed as they affected the actual design for functioning and installation of the windfarm, but were not allowed to the extent they were used for modelling projected electricity output. These differences in treatment demonstrate the level of analysis required before a conclusion on deductibility can be drawn.

Project management costs

Separately, the project management costs were allowable, following the long-standing acceptance of ‘incidental’ costs of acquisition and installation being allowed, such as professional fees, to the extent they can be attributed to the provision of equipment subsequently installed.

Analysis

The case is important as it is clearly the most detailed and relevant case on whether preliminary studies can be regarded as qualifying expenditure for PMAs.

While it is an important decision for expenditure on windfarms, it will also be of potential relevance to other projects such as alternative energy projects, energy transition projects and for development expenditures incurred in the upstream oil and gas sector.

In relation to the costs judged as qualifying for PMAs, the judgment raises a number of issues:

• Timing – how companies can determine if study costs prior to finalising the procurement of equipment and prior to settling upon the installation method are allowable? The case did not have to deal with this practicality as these were initially pre-trading expenses, all treated as incurred on the commencement of trade once the actual plant had been in place.
• Abortive expenditure – if the work is in preparation for a project that does not proceed, or equipment that is not procured or installed, the question arises as to what relief might be available. In order for expenditure on the provision of plant to qualify generally, such plant has to be owned by the company as a result of incurring the expenditure. Although the abortive expenditure rules provide for deemed ownership, these may not always be in point, depending on the precise contractual arrangements. A difficultly therefore arises for companies with on-going trades in assessing whether this ownership test can be met. This may be a particular difficulty for companies which might otherwise have claimed these types of costs under the mineral extraction allowances (MEA) code in the past. MEAs are not available for expenditure on the provision of plant regardless of whether that expenditure is abortive and even where such expenditure does not qualify for PMAs. The effect of this decision could, paradoxically, mean that there is greater risk of certain planning costs failing to attract relief or, at the very least, not qualifying for first year allowances (FYAs).
• Disposal values if work is transferred – if studies are undertaken by an affiliate, is there a disposal of an interest in plant and machinery, notwithstanding there is no identifiable asset? Alternatively, can the uncompleted work represent an intangible asset, subject to the intangible asset regime?
• Reclaim of Ring Fence First Year Allowances – where plant and machinery is not used within the ring fence within 5 years of the expenditure being incurred (as a very broad outline of the rules) FYAs are withdrawn (if they were claimed). Companies considering relying on the judgment to claim PMAs for design expenditure may choose to opt to claim writing down allowances instead.

Overall

Companies engaged in pre-development work and studies should carefully consider the potential for capital allowances to be claimed using the lessons from this case, and also be aware of the consequences of such claims.

Whilst this case may extend the scope of expenditure which falls within the plant machinery regime, for many projects there may be significant study and design costs which would not be in scope. Oil and gas companies may be able to fall back on the mineral extraction allowance code but for companies that do not carry on a mineral extraction trade there may be categories of expenditure which could fall down a gap and be treated as tax nothings. This is an unsatisfactory state of affairs given the push to develop alternative sources of power and the move towards “net zero”. 

We recommend that any company about to commence a long-term project carefully considers how the initial design and planning costs are likely to be treated for tax purposes, and to the extent they may not qualify for relief examine whether alternative ways of structuring the commercial arrangements might produce a better answer.

KeyFacts Energy Industry Directory: CW Energy