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Hotels
and the Tax Based Investor
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John
Heffernan
Tax Partner – Limerick
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If
you have significant Irish rental income, chances
are that at some time you have considered investing
in a hotel as a tax shelter. Based on the number of
pipeline projects that might come on stream next year,
it looks like you could have a lot of choice. But
does it make commercial sense?
When does an industry react to falling demand by dramatically
increasing supply? The answer: When tax relief is
involved, or more particularly, when that tax relief
is about to come to an end. How else do you explain
the number of new hotel projects in the pipeline?
For
many years, investors could write off capital expenditure
incurred on the development of new hotel projects
and on hotel extensions over a seven year tax life
against all sources of Irish rental income. For new
capital expenditure incurred on or after 1 January
2005, the write off period is extended from seven
years to twenty five years. Essentially, this is the
death knell for tax based investment in hotel projects.
However,
the seven year write off period can be retained for
hotel projects where planning permission for the project
has been applied for on or before 31 December 2004
and capital expenditure has been incurred by 31 July
2006, although there are expectations that this completion
deadline will be extended. The planning permission
application deadline of 31 December 2004 can be the
only explanation for the stampede of planning applications
made for new hotel projects in the weeks and days
leading up to the 31 December deadline. According
to research undertaken by RTE’s Prime Time programme,
planning applications were made for 220 new hotels
containing 15,122 new hotel rooms in the period 1
November to 31 December 2004. Amazingly, were all
of these projects to come to full fruition, the stock
of hotel bedrooms in the country would increase by
one third over current levels.
Is
there any evidence that the demand for occupation
of hotel rooms is likely to grow in the coming years
to meet this massive additional supply? The evidence
actually points to the contrary. According to Failte
Ireland’s own research, room occupancy levels
across all regions were 5% below the 2000 levels in
2004. Capacity has increased at a faster rate than
demand over the 5 years to 2004. Also the average
length of hotel stay has shortened over the same period.
Room occupancy rates in Irish hotels in 2004 were
on average 60%, hardly a level to inspire a massive
expansion of our hotel room stock.
Perversely,
the commercial reality does not always influence the
tax based investment market. Individual investors,
who acquire stakes in hotels for the purpose of sheltering
rental income from tax, do so not as long term hotel
investors. Instead, they enter the market as purchasers
of tax allowances. Typically, the tax based investment
scheme is structured as a seven year investment. The
hotel investors form a syndicate to fund the development
of a hotel project. The investor group then leases
the hotel back to the operator for a fixed rent over
a seven year period. At the end of the seven year
tax life, the operator (or the developer) buys back
the hotel from the investors at a discounted fixed
price.
All parties to this investment scheme obtain significant
benefits. The investors get access to a bank of capital
allowances without taking any significant financial
risk. The developer is able to achieve a premium price
on the hotel project. The operator is able to obtain
use of the hotel for seven years at a discounted rent
and buy the hotel in year seven at a discounted price.
The
most critical player in the transaction is the bank
as the tax based investor would expect the annual
rental income and the buyout in year seven to be guaranteed
by a bank. If the banks lose their appetite for hotel
projects, then many of the planned new projects will
never see the light of day. Tax based investors are
becoming increasingly sophisticated and will typically
seek out fully bank guaranteed projects. If the banks
are not prepared to provide these guarantees, then
the developer will not be able to attract the tax
based investors and the whole basis for the project
falls away. If there is no strong commercial underpinning
for the project then it is probably only fair that
the project does not proceed in the first place. The
banks are now essentially the marshals in this process.
Their decision on the provision of finance and the
provision of investor guarantees is now the most critical
element in determining whether a hotel project will,
or will not, proceed.
Amendments
to Planning
Even
if a project can be supported by the bank and can
attract tax based investors, the 31 December 2004
planning cut off date can cause some unforeseen problems,
and indeed without very careful navigation of the
planning system, projects could unwittingly fail to
obtain the tax relief originally intended. The difficulty
arises where amendments are sought for a planning
application that was originally lodged before 31 December
2004. The Revenue issued a statement in Tax Briefing,
Issue 60, in August 2005 clarifying their view on
this matter. They have confirmed that tax relief under
the old rules will only be available in respect of
expenditure incurred on work “that is covered
by a valid application for full planning permission
that was received by the relevant local authority
on or before 31 December 2004…..It should also
be noted that where a valid planning application for
full planning permission was received on time, relief
is only available in respect of expenditure on actual
work covered by that particular application. It does
not extend to expenditure on additional work as would
arise where the applicant decides to extend the scale
of the project subsequent to the qualifying application
deadline”.
In
this statement the Revenue go on to say that they
are “concerned at some notices that have appeared
in some newspapers after the 31 December 2004 deadline
indicting that “significant further information
has been lodged with ________County Council under
planning reference xxx 2004”. In some cases
the “significant further information”
referred to would have the effect of substantially
increasing the scale of projects already submitted”.
The position taken by the Revenue is that only expenditure
incurred on the basis of the original project could
qualify for relief and that expenditure incurred on
any extension or addition to a project will not qualify
for relief. In such a situation it would be necessary
for the total expenditure to be apportioned between
the qualifying and non-qualifying work. If, on the
other hand, the planned extension gives rise to the
need to make a further planning application after
31 December 2004 to cover the revised or extended
project, then none of the expenditure incurred on
that project will qualify for relief. Great care needs
to be taken if there is a need to materially adjust
the project from the project that was the subject
of the planning application made on or before 31 December
2004.
Guesthouses
and Tax Relief
There
has long been an unresolved issue in relation to whether
a guest house can be categorised as a “hotel”
for the purpose of the tax allowance. The Revenue
have generally resisted such claims, although, in
certain limited circumstances, a strong case could
have been made to support this contention. The issue
was put beyond doubt in the 2005 Finance Act which
introduced two new significant provisions for hotel
capital allowances. These are:
It
is now necessary for a hotel to be registered in the
Register of Hotels kept by Failte Ireland under the
Tourist Traffic Acts in order to qualify for capital
allowances in respect of expenditure incurred on the
building on or after 3 February 2005. This is a new
condition and did not apply to hotel capital allowances
before. This new registration requirement is, however,
subject to transitional arrangements. Where the conditions
for transitional treatment are met, the requirement
to be registered as a hotel with Failte Ireland for
capital allowance purposes is deferred and will only
apply in respect of capital expenditure incurred after
31 July 2006. Generally speaking this new condition
will not apply to hotel projects where the planning
application was submitted on or before 31 December
2004 and is therefore generally not likely to have
any material impact on tax based hotel projects.
The
second change that was made was to clarify the position
in relation to guesthouses. Capital expenditure incurred
on or after 3 February 2005 on premises used as a
guesthouse will for the first time qualify for capital
allowances provided the guesthouse is registered in
the Register of Guesthouses kept by Failte Ireland
under the Tourist Traffic Acts. However, in line with
the new regime for hotels, allowances can only be
claimed at the rate of 4% per annum and, therefore,
this is unlikely to attract tax based investors. The
Revenue have also confirmed that this new provision
in relation to guesthouses does not have any immediate
effect on the small number of guesthouses that have
already established an entitlement to capital allowances
on the basis that they were effectively operating
as hotels.
The Future For Hotel Developments.
Two major obstacles are in the way of raising funding
for new hotel projects. First of all, the extraordinary
level of pipeline projects prompted by the 31 December
2004 cut off will make it very difficult to obtain
either bank commitment or investor interest in new
projects. Secondly, the increase in the write off
period for tax purposes from seven years to twenty
five years will signal the death knell for tax based
investment in hotel projects.
For
the future, it will take some time before the market
can absorb the number of new projects coming on stream.
Once these projects are completed and the market adjusts
to the additional capacity, the prospects for future
new hotel developments will become clearer. However,
in the absence of a strong recovery in room occupancy
levels (particularly outside of Dublin and the major
centres) and in the absence of any new tax relief
for hotel developments, it is unlikely that there
will be any serious investment appetite for hotel
projects for some considerable time to come..
It
is interesting to note however that the Government
has not closed the door on re-introducing significant
tax relief for hotel projects. On 9 April 2005, Minister
for Finance Brian Cowan announced the award of two
external consultancy contracts to undertake a detailed
review of certain tax incentive schemes. One consultancy
firm is examining the area based urban, town and rural
renewal schemes and the living over the shop schemes.
The other consultancy firm is examining various sectoral
property tax incentive schemes including hotel schemes.
Whether, arising from this study, the Government is
prepared to re-introduce tax incentives for the hotel
sector remains to be seen. However, given the current
potential for significant over supply of accommodation
in the tourism market, it is difficult to see how
the consultants could recommend a reintroduction of
substantial tax reliefs on a wide scale basis for
hotel projects. I understand that the reports have
not yet been completed, but the Minister did give
a strong hint in the Dail on 1 June 2005 that all
will be revealed on Budget Day.
If
you are looking for a tax shelter and you still want
to proceed with a hotel investment, be sure to check
that the bank are guaranteeing the annual rent and
the buy out in year seven and that the project is
fully compliant with a planning permission granted
on foot of an application made on or before 31 December
2004
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