With the rapid development of the market in natural capital assets over the last few years, the government is struggling to ensure that its legislation and guidance on matters such as taxation keeps pace with the growth in these markets. The recent launch of a consultation on the taxation of environmental land management and ecosystem service markets is therefore very welcome and long awaited by landowners.
This article considers some of the broader taxation themes that have emerged as deals have been put together. It is therefore focussed on headline structuring considerations and will leave detailed responses to the consultation to our tax specialist lawyers.
There are many obstacles to the market development of the new asset class of natural capital and the fear of adverse taxation consequences is the largest. Those considering exploitation of natural capital on their land should pause at a crossroads where the thoroughfares of long-term land management and fiscal prudence intersect. Decisions taken will be far reaching and will be considered at leisure over the next 30-125 years depending on the landowner’s scheme of choice.
The roundabouts of early adoption might be mitigated by the swings of being in the vanguard but at this stage nobody knows. What we do know is that, for example, the market for nutrient neutrality credits has probably been pared back from 2030 onwards if the Levelling Up Bill makes it to the statute book unscathed.
The proposed redistribution of cost from the developer to the water companies caused by the requirement to upgrade waste water treatment works has been welcomed by many. The impact on the market will be very location specific, but in recent projects we have seen, the credit requirements will be halved (post 2030). This raises the possibility of short-term agreements to tide developers over for the next 7 years or so, together with the flexibility to sell off excess credits post 2030.
Whatever the structure, the government is understandably keen to see the private markets for ecosystem services flourish as there is simply not enough public money to go round. The consultation focusses on the tax treatment of the various credits that can arise from the exploitation of natural capital. These are broadly:
These credits are the manifestation of the environmental improvement achieved and are underwritten by the habitat created or nutrient run-off mitigated.
The first part of the consultation asks what the main uncertainties in the taxation of trading and other income are which arise from such credits.
Much will depend on the structure adopted but for many landowners they will either be utilising their own land or leasing it out to a third party, who will create habitat to produce BNG credits for example.
This immediately creates a choice of creating trading or investment income with all the implications that then brings for Balfour planning in a Business Property Relief (“BPR“) context for inheritance tax.
If the lease route is taken, then rental income would be chargeable to income tax, but the impact of any premium paid would see a split liability with part chargeable to income tax and part to capital gains tax.
The sums involved in terms of rent and/or premium will also then dictate whether a Stamp Duty Land Tax (SDLT) liability is incurred. The long-term nature of the leases mean that relatively modest rents will see the threshold exceeded, even before adding on the premium.
The main income tax uncertainties appear to concern how the monies received for the credits are treated. We have seen many permutations recently with credit prices expressed as a gross figure or split into unit cost and habitat creation/management costs.
The nature of the transaction is the creation of value through the management of land in a certain way. On one level that could be seen purely as an income receipt, being a return for active management of the land. Alternatively, it could be viewed as a payment for a right over land – the cessation of agricultural use for nutrient neutrality purposes for example.
The creation of habitat for BNG purposes could be split between initial establishment works and later maintenance/management tasks. They, once again, have a capital and income feel to them respectively. Even where payment is made for everything up front it would be possible to apportion the income over the long term of the lease or to distinguish between establishment works and maintenance for the purposes of taking advantage of the recently enhanced capital investment allowances.
The restrictive nature of the nutrient neutrality regime (however that is achieved and enforced) could amount to a partial disposal for capital gains tax (“CGT“) purposes.
Such a distinction would suggest a possible split of income and capital receipts once again. The treatment of the sale proceeds for the credits may come down to the individual preferences and circumstances of the tax payer.
The fundamental trading or investment model is also relevant here as the useful CGT reliefs may not be available if land is utilised for ecosystem services.
If the land is leased for these purposes, it may result in the loss of Agricultural Property Relief (“APR“) if the habitat creation works for BNG are sufficient to exclude agricultural use. That will certainly be the case for nutrient neutrality as agricultural use must cease. In these circumstances the loss of APR will be compounded by the fact that BPR cannot be claimed, as the lease is an investment and not trading activity.
Those combined factors mean that holdover relief will not be available on a gift of the land. That relief would have allowed the recipient to use the base value of the land on acquisition by the donor thereby usefully deferring the CGT liability.
Use of the lease structure has further ramifications because the absence of business trading denies the availability of roll over relief, which sees any capital gain subsumed into the purchase of a qualifying asset.
The much reduced, but still useful, Business Asset Disposal Relief which sees the rate of CGT reduced from 20% to 10% (where a business ceases and its assets are sold) would also be unavailable unless the business is substantially a trading entity.
The second part of the consultation addresses the main area of concern which is inheritance tax and the possible loss of valuable APR and BPR.
APR is only available in respect of land occupied for the purposes of agriculture and the obvious concern is that habitat creation is not an agricultural use.
The desire to assist landowners in retaining APR has seen some habitat brokers like structure their deals using FBTs. That is a perfectly legitimate strategy where the habitat creation retains an agricultural flavour – as it often will where conservation grazing or low intensity fodder conservation is planned.
This is clearly a question of fact and degree in every case; the creation of wetland will not be agricultural, whereas the creation of a mosaic habitat of scrub and low intensity grassland will probably fall on the right side of the dividing line.
It must be remembered that APR will only relieve the agricultural value of the land and so if there is any enhanced value resulting from the leasing of the land to a third party or the landowner’s own scheme, this will not be sheltered. Any such uplift may be protected by BPR if the qualifying criteria are met.
One of the problems with some ecosystem services is that they are more about what the landowner doesn’t do than what they actually do. Nutrient neutrality is a good example as the landowner is simply obliged not to farm. This absence of activity on the land has been held to be a very good indicator of no business use in a number of high-profile APR and BPR cases in recent years. In those circumstances the availability of BPR will come down to the overall Balfour balance between trading and investment activity across the whole enterprise.
The increase in value (if any) attributable to ecosystem services is a subject of considerable current debate. Many institutional landowners are not recognising any such increase in land values but are instead preparing separate natural capital accounts. There is no doubt that the land market is being affected by the market for ESG Credits but localised pockets of demand (often catchment area specific) and substantial increases in more marginal quality land does not lead to an easy application of a convenient percentage uplift for say standard arable land.
Other issues also cloud the picture as the value of a rental income stream over a long term may well be offset by the perception that other options have been closed off and the concern about the residual value of the land at the end of any such long term undertaking.
The replies to the consultation will be interesting but stakeholders involved in these emerging markets keenly await the arrival of tangible guidance and secondary legislation under the Environment Act 2021.