UK: RSL Issues - A Briefing for Registered Social Landlords

Business Planning - What Lies Beneath
Last Updated: 6 April 2006

Over the past three months, we have been involved in reviewing or validating six different RSL group business plans. Each was structured differently, but there were a number of common features that it might be helpful to highlight.

Surplus shortage
By Jonathan Pryor

For those RSL groups with active development programmes, the amounts of money flowing into the group from grants or other subsidies are huge. The consequence though is the highest rate of increase in both debt and gearing levels that the sector has ever faced. Since most developments require considerable initial net cash outflow to be repaid over a prolonged period – often in excess of 30 years – this is hardly surprising. But it is placing significant pressure on the income and expenditure account and, in particular, the interest cover.

For some time, the sector as a whole would have been reporting a net loss were it not for property disposals. However, this rapid expansion means that for some RSL groups, even a significant property disposal programme will be insufficient to generate a reported surplus.

Formulating assumptions
The models we have seen have been based on an overall set of assumptions along the following lines.

  • Inflation levels for salaries, maintenance costs and development works will not be far away from those experienced in respect of rental income (usually around RPI+0.5%, adjusted for the effect of rent restructuring on existing stock).
  • In some cases, a major dependency on the availability of significant surpluses derived from property disposals and, in particular, from shared ownership, fuelled by ever-rising property prices with inflation levels substantially ahead of inflation (say RPI + 3%).
  • There will be significant economies of scale and relatively modest increases in employee numbers despite the expansion in unit numbers. This will be true for not only front-line employees but support staff as well.
  • Development will cease within a relatively short period (usually in five to ten years from now).

This overall picture of significant economies of scale and benign inflation may be achieved by some RSL groups, provided there is sufficient management focus and attention. However, in our opinion, there are many reasons for believing that the sector as a whole will be unable to deliver these projected results.

Pension costs, rising expectations in health and safety and building quality, Government initiatives to extend the scope of RSL responsibilities, and shortages of maintenance and development contractors, staff and materials (particularly in the south east of England) are but a few of the pressures that the sector and other organisations face. If property prices rise, as assumed in the models, then you can bet your bottom dollar that land and build costs will too.

Although smarter ways of working and the general pressure on improved efficiency may achieve some savings, these will have to compete against a very strong headwind.

Basic errors
If all this were not bad enough, most of the models we reviewed included some extremely basic errors. Formulae that did not include all of the required balances, inter-company charges that somehow delivered an internal profit, overdrawn cash balances on which no interest was charged, and cells with hard coding where the assumptions ought to have been changed are just a few examples of the errors we encountered.

In most cases, but with some exceptions, the use of external consultants to prepare the models did not result in any improvement in the quality of the model; indeed, one could argue the opposite.

Stop and reassess
As a result of the expanded development programme, in our view, it has become more important for RSLs to assess their forward financial position using a tool such as a long-term business model. However, our recent experiences have reinforced our belief that many of these models are poorly prepared, with numerous formulae and logic errors and, in some cases, excessively optimistic assumptions.

Ultimately, this suggests that quite a few RSL groups, currently rejoicing in substantial levels of funding, could be heading for a fall.

Health warning! FRS25 could seriously damage your balance sheet
By Emma Brett

Tucked away in the dark recesses of Financial Reporting Standard 25 Financial Instruments (FRS25): ‘Disclosure and Presentation’ is guidance that could have a significant impact on the net current assets of some RSLs.

While the majority of FRS25 is not applicable to RSLs, paragraphs 50A to 50E concern all RSLs for accounting periods starting on or after 1 January 2005.

These paragraphs provide guidance on the split of loans between current and long-term liabilities, and prescribe that the accounting treatment will be dictated by the year-end position. Essentially, this means that there will be no adjusting post balance-sheet events in respect of loan disclosure, which will have a major impact on refinancings, rectification of breaches, and agreements to periods of grace that take place after the year-end. These are non-adjusting events that only lead to disclosure in the narrative of the notes rather than determining whether the loan is current or long term.

Refinancing issues
FRS25 states that all loans should be treated as current liabilities in their entirety if they are to be repaid within 12 months of the year-end. This applies even if they were originally for a longer period and even if an agreement to refinance or reschedule payments on a long-term basis was completed after the balance-sheet date and before the accounts were approved.

Therefore, if facilities are due to expire within 12 months of the year-end and the refinancing or rolling over of the obligation is not at the discretion of the RSL (for example, there is no agreement to refinance), the loan is classified as a current liability and the potential to refinance is not considered. This remains the case even if the refinancing was completed shortly after the year-end.

Covenant breaches
If a covenant is breached before the yearend, the loan is classified as a current liability unless the lender agrees – prior to the yearend – to a waiver or grace period beyond 12 months from the balance-sheet date. This applies even if after the year-end the lender agrees to a waiver or grace period.

Planning ahead
If FRS25 could have implications for you in terms of potential refinancings or covenant breaches, it is essential that you obtain written confirmation from your bank, prior to the year-end, to avoid unfavorable disclosure of your loans as current liabilities.

FRS21 – More Relevant Than You First Thought
By Julie Mutton

Financial Reporting Standard 21 – ‘Events after the Balance Sheet Date’ will, for the first time, apply to most RSLs for accounts to 31 March 2006.

At first glance, FRS21 would appear to tidy up the previous standard (SSAP17), and to present requirements in line with the continuing convergence of UK and International Standards. However, two paragraphs indicate that the way bonuses and dividends are considered after an entity’s results are known is no longer acceptable. By implication, Gift Aid payments between group entities will also require careful handling.

Bonus planning
FRS21 provides a specific example of a situation where the accounts may be adjusted for an event after the balance sheet date:

"the determination… of the amount of… bonus payments, if the entity had a present or constructive obligation at the balance sheet date to make such payments as a result of events before that date".

Contractual bonus schemes do not pose a problem as there is a legal obligation to pay a bonus at the end of the year, even though the exact amount may not be finalised until the organisation’s results are known. Discretionary bonuses, on the other hand, which are based on performance in the year to 31 March 2006, may only be recognised in that period’s accounts if a ‘constructive obligation’ has been created.

FRS12 – ‘Provisions, contingent liabilities and contingent assets’ explains that a constructive obligation arises when an entity has ‘created a valid expectation’. Individuals would need to be notified of any potential bonuses in order to create this expectation and permit accrual in the accounts. It may be appropriate to send a letter to the recipient stating that a bonus will be paid and indicating the amount or how the amount will be derived. Such a letter would need to be dated and sent before the yearend to ensure that a constructive obligation exists at the balance sheet date. Care should be taken not to trigger a Pay As You Earn liability at this point.

Dividend payments
FRS21 states that "if an entity declares dividends… after the balance sheet date, the entity shall not recognise those dividends as a liability at the balance sheet date". Dividends will only be allowed to accrue in the accounts if they represent a binding legal obligation at the balance sheet date. Under UK company law, a dividend only becomes a binding obligation if it has been paid or if shareholders approve it at a General Meeting (or, in the case of a private company, if it’s approved by written resolution).

In group situations, where a subsidiary is declaring dividends to pay the parent company, the dividend can also be treated as ‘paid’ if an accounting entry is put through the books of both entities, setting off the proposed dividend against an existing liability that the parent owes the subsidiary (as long as the liability is not reduced below zero).

Gift Aid payments
FRS 21 does not specifically mention Gift Aid, but the Statement of Recommended Practice ‘Accounting by Registered Social Landlords’ (update 2005) picks up this angle.

"The determination after the balance sheet date of the amount of a Gift Aid payment… is an adjusting event if [there is] a present legal (e.g. a deed) or a constructive obligation at the balance sheet date. Where a present obligation is demonstrable at the year-end, an adjustment is made where post balance sheet calculations provide greater accuracy in the measurement of the existing liability, e.g. to equate the Gift Aid liability more closely to taxable profits".

Again, the principle is that as with bonuses and dividends, an obligation needs to exist at the year-end in order to reflect the transactions in the accounts to 31 March 2006.

Going forward
Planning ahead and a good set of management accounts are essential for RSLs to forecast annual results with reasonable accuracy. Such information will determine whether dividend, bonus or Gift Aid payments will be appropriate. Timely action should also be taken to ensure that paperwork is in place to demonstrate the obligations on the entity to make payments after the year-end date. 

Pension Schemes – Employer Beware
By Andrew Bond

In our last newsletter, we highlighted how employers withdrawing from final salary pension schemes, including the Social Housing Pension Scheme (SHPS), will potentially need to pay their share of any defined benefit deficit, calculated on a buy-out basis, under the Occupational Pension Schemes (Employer Debt) Regulations 2005.

This can be extremely costly and is impacting on a number of mergers within the sector. Lawyers appear to be making progress with The Pensions Regulator in some of these cases, although discussions with the Department for Work and Pensions are not expected to conclude for another year or more.

However, even without the problems relating to mergers and acquisitions, pensions schemes, particularly those providing defined benefits, continue to prove an expensive financial proposal for the employer. Falls in annuity rates and higher-than-anticipated salary inflation, as well as increased life expectancy, have made it difficult to claw back deficits.

The largest defined benefit scheme in the sector, SHPS, which is administered by the Pensions Trust, has recently issued a paper to scheme members seeking a mandate to introduce a choice of benefit and funding structures within the fund. It also highlights the fact that the funding position of the scheme, which was 85% in 2002, is likely to have deteriorated since then, although exact results are not yet known. Therefore, without radical restructuring of benefits, associations can expect to see employers’ costs rising significantly.

Unlike those schemes which account for pension obligations by reflecting deficits on the balance sheet under FRS 17, the full weight of increased contributions will be felt in the I&E account unless the Pensions Trust is able to identify the separate assets and liabilities for each employer after all.

Such concerns may be exacerbated in the medium-to-long term by the Government’s agenda, which could see employees opting out of, rather than into, pension schemes. Many housing associations could see their payroll bill increase significantly if take-up rises as a result of this change in approach.

Finally, the pensions environment will change fundamentally on 6 April 2006 or ‘A-Day’. Subject to transitional provisions, individuals will have a statutory lifetime allowance permitting them to accrue no more than £1.5m through their pension and lump sum death inservice arrangements. There are also significant changes to the rules regarding contributions, tax-free cash, retirement ages, retirement annuity contracts and other areas, while a levy to the Pension Protection Fund will increase costs.

In short, RSL management teams and boards will need to check that their pension arrangements are up to date and that they are willing to accept the liabilities attached to them. If they have not seen it already, RSL boards ought to be looking at a paper summarising these issues and considering their association’s response in the near future.

VAT- Captivating Interest
By John Voyez

As a market sector, RSLs are probably the largest developers of residential accommodation in the UK today. The growing desire of local authorities to include an element of social housing as part of the planning gain arrangements has also brought RSLs onto the radar of private developers of every size. As a result, property transactions involving RSLs are becoming increasingly complex.

There are two VAT issues that RSL developers generally have to address.

First, VAT can only be recovered on the development of properties for shared ownership or those for outright sale. Therefore, VAT incurred on developments for the rental market represents a bottomline cost.

The second issue concerns the purchase of a VAT-opted site. In short, this means purchasing land or property for residential development on which the vendor intends to charge VAT, which may be irrecoverable in the RSL’s hands. There are ways of resolving this problem, such as the golden brick scheme, where a contractor buys land, reclaims the VAT and then sells on to a housing association once there is at least a row of bricks above the foundation so that the sale is accepted as zero-rated. In practice, this can lead to its own set of complications.

So what is the answer?
Many RSL groups are looking to establish a captive development company outside of their existing VAT group. The advantage of this is that such a company can acquire land or property and develop it so that any VAT cost is ‘washed through’.

For example, if an RSL wishes to acquire an opted site for developing residential accommodation for letting, the VAT on the cost of the site plus all professional fees (typically 10% of the total cost) will be irrecoverable subject to entering into golden brick arrangements, although this may still leave VAT on certain professional fees irrecoverable. However, if the development company acquires the site, constructs the units and then grants a freehold interest or long lease to the RSL before letting takes place, the project becomes VAT free due to the way in which the VAT legislation works.

Furthermore, the use of a development company rather than an RSL means that outright sales can be made to cross finance other developments. Such sales may well be ultra vires for most RSLs. The development company is able to compete for sites on the same footing as private developers.

The use of a captive development company in this way generally gives the RSL group much more flexibility in the way it develops property. It makes certain projects, which may have otherwise proved too difficult for most RSLs, e.g. the acquisition of opted sites, feasible.

There are a number of other non- VAT issues to be considered including direct tax, accounting and funding of the development company. These are generally resolvable and, indeed, there are also advantages, e.g. incentivising the development team.

While this is only a brief overview of some of the VAT issues relating to the use of a captive development company, they should be considered by RSL groups actively developing sites.

Gift Aid – Dotting the ‘i’s and crossing the’t’s
By Trudi Amy

Many RSL group structures include a charity and a noncharitable, tax-paying group member.

The recognised method of sheltering profits from tax in the taxable entity is to gift the profits to the charity and secure a corporation tax deduction for the payment. Many such payments are made in the nine months following a year-end to ascertain profits and avoid over or under-payments. 

Below is a flowchart outlining how and when a payment can be made.

Points to note:

  • Due to the restrictions on the shares and spread of share ownership, a ‘whollyowned subsidiary’ may not include an industrial and provident society or a company limited by guarantee.
  • A transfer to an inter-company loan or current account is not sufficient to satisfy the cash payment requirement.
  • There must be no strings attached to the gift, e.g. an expectation of a loan back.
  • Payments in excess of the taxable profits can be group relieved but not carried forward against future profits.
  • Rules introduced in 2002 permit the gift of land or property, rather than cash, to a charity. Such gifts must be made within the accounting period to secure tax relief for the market value of the land.
  • The rules concerning the deduction of Gift Aid payments to shareholders currently do not apply to entities jointly owned by more than one charity. This is being reviewed.

We have taken great care to ensure the accuracy of this publication. However, the publication is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Limited 2006.

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