Investors in renewable energy assets are able to claim tax relief in the form of capital allowances on certain expenditure. Capital allowances relief against taxable income will often be included in the financial model on transactions. For investors, there may be risk where capital allowances have been incorrectly calculated, overstated or misallocated and not available for utilisation as modelled by investors. By proactively managing the risk, investors can ensure that their future profits are adequately protected.
What are capital allowances?
In the UK, a business which invests in plant and machinery (P&M) for use in its trade or rental business cannot claim a tax deduction for that capital expenditure (nor for the depreciation of the P&M) as a general rule.
Instead, such businesses may claim capital allowances – a form of UK tax relief for capital expenditure on certain business assets- allowing businesses to write off the cost of qualifying P&M over a period of time. By claiming capital allowances, a business can effectively reduce its annual taxable income.
Although capital allowances are relevant to all businesses that invest in P&M, they are particularly important for renewable energy businesses, which typically invest a large proportion of their capital in P&M to generate electricity or heat.
Calculating capital allowances
Capital allowances are available at the relevant rates prescribed by the Capital Allowance Act 2001. Expenditure which qualifies for capital allowances is “pooled”, i.e. aggregated for the purpose of calculating the capital allowances that may be claimed by the business in each of its accounting periods. There are three types of pools, as outlined below:
The "special rate pool" to which an annual 6% writing-down allowance applies. This pool contains expenditure on qualifying assets designated as ‘special rate pool P&M’ – this includes “long-life” assets (i.e., many types of solar, wind and other renewable energy assets with a useful economic life of at least 25 years), among others.
The "main rate pool" to which an annual 18% writing down allowance applies. This pool contains expenditure on qualifying assets designated as ‘main pool P&M’ – this includes all other P&M assets not designated as ‘special rate pool P&M’.
Single asset pools which attract writing down allowances with an annual rate of 18% or 6% depending on the asset in question.
The pool into which an item of expenditure falls is determined by reference to the type of plant and machinery in question (and its designation as a ‘special rate’ or ‘main rate’ asset). Capital allowances are granted on a reducing (rather than a straight-line) basis on the balance in each pool during an accounting period.
Enhanced capital allowances (giving accelerated relief) are also available, providing targeted incentives to encourage business investment in particular types of plant and machinery, which include biogas equipment and electric vehicle charging points. In addition, since April 2023 'full expensing' (i.e. 100% first year tax deductions) has been available for qualifying expenditure on certain kinds of new and unused plant and machinery, including many types of renewable energy equipment. The full expensing regime replaced the earlier “super deduction” regime that applied between 2021 and 2023.
Why are capital allowances an important consideration in transactions?
Investors frequently want to hedge against the risk that the target’s capital allowances have been:
Incorrectly claimed
Overstated
Misallocated between the main rate and special rate pools
Erroneously included in a “full expensing” or “super deduction” claim
There is also the risk that the target company may not be able to claim capital allowances expected to be available to reduce taxable profits in post-acquisition-periods, which were factored into the financial model and business case to make the investment.
As a general rule, HMRC can re-open a corporation tax return (e.g. to challenge capital allowances claimed in that return) up to six years from the end of the accounting period to which the return relates. However, this time limit reduces to four years where any inaccuracies in the tax return are not attributable to “carelessness”.
It is therefore essential for investors to ensure that modelled capital allowances are available to shelter taxable profits in future periods or have been used correctly to shelter taxable profits in the preceding tax years.
Mitigating risk: transactional risk insurances
Lockton has extensive experience in placing transactional liability products on renewable energy transactions and working with strategic insurers. Below, we assess some of the key considerations for investors to consider when procuring transactional liability insurance.
As is customary, insurers will require a commensurate analysis of the capital allowance position to be conducted. Focusing on warranty and indemnity insurance (W&I) more particularly, strategic markets will consider cover for unknown risks or other less material identified risks in nature and quantum, by way of affirmative cover.
For material and or higher quantum risks which are identified, strategic tax and contingent markets can consider providing cover under a bespoke policy. For identified or contingent risks, markets will require the risk to be adequately analysed (in nature and quantum), which allows insurers to ring fence the risk and exposure, which they would then underwrite. The simplistic take away in regard to covering identified risks for markets is: if the insured party can present a defensible position to insurers for why the filing position supporting the availability of the capital allowances is robust, tax/contingent risk insurance should be available.
Ideally, investors would either:
Commission a detailed capital allowances review as part of its buy-side due diligence exercise; or
Obtain copies of the capital allowances reports commissioned by the target at or around the time it incurred the expenses, so buy-side tax advisers can review/comment on the adequacy of those reports and whether the target’s historic capital allowance claims were in line with those reports.
Markets are typically more comfortable covering capital allowances for solar and wind assets, as these assets and their operations along with reporting are generally more consistent.
We have included some high-level commentary below which details indicative underwriting conditions and the corresponding rationale which markets use to assess cover on select renewable energy assets.
Asset | Underwriting conditions | Rationale |
Solar | Typically, no mandated exclusion at the stage where non-binding indications (NBI) on cover are received from markets assuming: • 10% main pool / 90% split special rate pool. Deviation typically acceptable for up to c.20% v 80%; and • Expenditure should be in line with expectations and tax advisers’ experience when analysing capital allowances. | Most solar expenditure is special rate expenditure under the Capital Allowances Act 2001. |
Wind | Typically, no mandated exclusion at NBI stage assuming: • Main pool expenditure is around 80%-90% of total expenditure. • Expenditure should be in line with expectations and tax advisers’ experience when analysing capital allowances. | The primary qualifying assets are the turbines themselves, which should be in main rate pool (as a general rule). The special rate pool expenditure is likely to be a small overall percentage, primarily reflecting grid connection costs. |
Hydro, Biomass & Battery Storage | Typically, more complex than wind/solar and dependent on the nature of the underlying project/asset. Exclusion may be applied for capital allowances at NBI stage, particularly for larger assets. Insurers will expect: • A standalone capital allowances report (by a reputable firm) has been commissioned in respect of the expenditure. • The advisors (to the extent different to the authors of the report) consider that the report is reasonable and that the pooled expenditure is in line with the contents of the report. | Significant capital allowances pools are expected for these assets, however the pool allocation is highly dependent on the nature of the individual projects. General sentiment from markets is that they would be hard pressed to make any general assumptions without reviewing the capital allowances report. |
Indicative guidelines and underwriting assumptions for transactional risk insurance
Ideally buy-side advisers will be provided with, and will review, capital allowance reports/studies that were commissioned by the target at the relevant time to assess the methodology used to designate an expense in either the main or special rate pool and be comfortable that the approach used was reasonable;
In relation to the Gunfleet Sands case (a recent tax tribunal decision which held that expenditure on various technical studies and surveys relating to the viability of a site for windfarm construction did not qualify for capital allowances), markets typically expect to see that the buy-side due diligence exercise has identified any expenditure for which capital allowances have been claimed that would be in contravention of that decision (if ultimately upheld following any appeals), to ensure that no value is attributed to those capital allowances;
Insurers would need to understand what value is being attributed to capital allowances overall (i.e. are buy-side paying £ for £ for the net present value (NPV) of the future tax relief that should be available from the capital allowances, or alternatively applying a reduction (e.g. only paying 20p for each £ of NPV attributable to future tax relief on the capital allowances acquired)) – Lockton usually see an investor agree to pay considerably less than par for capital allowances given the complexity of the area and often the unavailability of the allowances post-acquisition. The materiality of the risk is that some allowances will prove to be unavailable post-acquisition;
Markets would need the buyer to demonstrate how the non-availability of capital allowances that have been paid for would impact valuation and what the loss would be in this context. What this has meant is, investors or their financial advisers demonstrate the inputs/outputs in their valuation model so that insurers can see precisely how the valuation would be impacted;
Markets will typically apply a less stringent underwriting approach for older assets where standard HMRC enquiry/discovery periods are time-barred. Worth noting, that this will be applied on a case-by-case basis; and
Covering capital allowances on renewable transactions is a complex area and we’re seeing and hearing from markets that there are capital allowances totalling tens of millions for larger offshore windfarms. Therefore, if the quantum of cover is high, markets generally need to create a sub-limit in the W&I policy to cap losses or would suggest to a buyer that a separate tax or contingent policy is obtained with a separate underwriting fee and premium payable.
For further information on transactional risk insurance solutions on energy and infrastructure assets, please contact Jarrod Morgan-Evens (Solicitor and Vice President at Lockton Transactional Risk). This article also contains contributions from Mark Spinney, Counsel (Tax) at Ashurst LLP.
About Lockton
Lockton’s Transactional Risk – Energy and Infrastructure team is comprised of corporate lawyers and brokers with years of professional experience and expertise advising clients on the placement of transactional risk solutions on energy and infrastructure transactions.
About Ashurst
Ashurst’s globally renowned energy and infrastructure M&A, finance and tax specialists are highly experienced in guiding clients through capital allowances related issues in all transactional contexts.
The treatment of capital allowances on renewable projects and transactions or generally will require specialist input from advisers.
The above assumptions and discussion points are not exhaustive and are only intended to serve for informational purposes. The contents of this article should not be taken or construed as constituting any form of advice. We accept no responsibility or liability for the correctness and completeness of the information and conclusions provided. To the fullest extent permitted by law, we owe no duty, responsibility or liability, in contract, tort (including negligence) or otherwise. It is always recommended that in all instances, professional advisers are consulted, and each transaction or risk associated with capital allowances is considered on its own merits.
