by Anthony Davis
The rules, introduced by the Finance Act 1989, under which the VAT treatment of commercial property transactions was radically reformed have now been with us for over a year. The time is ripe for a review of the resulting safeguards which should ideally be sought by alert lenders to companies in the commercial property sector. It is true to say that a number of the possible areas of difficulty (and their solutions) as described below are not fully appreciated in some quarters of the banking community or among their professional advisers.
Effect of the new rules
So far as lenders are concerned the new rules are relevant in three main ways. The first is that VAT may now be payable on acquisition of commercial property, in certain cases compulsorily (notably on the purchase of a freehold of a building “completed” in the previous three years, subject to transitional relief) and in other cases by virtue of the vendor, lessor or assignor having elected to waive VAT exemption before the disposal. VAT is also payable on virtually all supplies of construction services relating to commercial buildings (the chief exception being those related to “protected” buildings). This affects the amount which a lender may be required to provide.
The second relevant change is that in order for VAT to be recoverable, it will in many cases be necessary for the borrower to elect to waive exemption from VAT in respect of supplies he proposes to make in relation to the property. The lender’s prospects of being repaid that proportion of the money lent may, therefore, depend on the appropriate procedures being available and correctly implemented.
And third, in the case of a commercial property which has been developed, a VAT charge on a notional “self-supply” (essentially, VAT becoming payable on all the costs associated with the construction, including the acquisition cost of the land) may arise up to 10 years after the date of completion of the building. If this came as a surprise, it could materially affect the solvency of the borrower.
Apart from the above, the lender will need to bear in mind the VAT treatment if it ever becomes necessary for him or a receiver appointed by him to realise the security and dispose of the property, since on a sale by a receiver or by a mortgagee in possession, any election to waive exemption previously made will still apply. This means that he may need to take steps to ensure that he knows whether the election has been made. The effects of a sale in ignorance of the VAT charge are described briefly at the end.
Funding acquisitions
The first point for a lender to satisfy himself on will be whether VAT is payable on the purchase price and that the borrower has, if necessary, allowed for the VAT. If, by mistake, the borrower fails to do so and the price is VAT exclusive, then he could be called on to pay the tax unexpectedly either on or before completion, or at a later date when Customs claim tax from the vendor. It is normally the case in transactions that unless VAT is allowed for specifically in the sale contract, or the contract can be construed through extrinsic circumstances as for a VAT-exclusive price, the price is deemed to be VAT inclusive under section 10(2) of the VAT Act 1983.
This is not, however, the case where the vendor elects to waive exemption on the sale between contract and completion. Then, under the express statutory provisions in section 42(1) of the VAT Act 1983, if the contract is silent on the point the VAT element is added to the purchase price. The lender should confirm that the purchase documentation gives appropriate protection to the purchaser in case of VAT being charged, ideally by providing expressly that the consideration is VAT inclusive unless a VAT charge clearly does arise, and also by providing that the vendor will not before or after contract elect to waive exemption (in those cases where he may do so) with effect from a date on or before completion.
Where it is envisaged that VAT is chargeable, the cautious lender may wish to satisfy himself that the conditions for the charge have been satisfied. This will be especially important to the lender where he expects to be repaid in whole or part soon after completion out of VAT recovered by the purchaser. The reason is that the fact of having paid VAT to the vendor is not of itself sufficient to enable the purchaser to recover it. The VAT must have been correctly charged in the first place, and the purchaser must hold the appropriate evidence (ie a valid VAT invoice).
Thus, on the purchase of a freehold which is newly completed, it may in appropriate cases be suitable to obtain (in addition to the invoice) confirmation of the date of completion and, in a case where VAT is chargeable by virtue of the election to waive exemption, evidence that notice of the election has been given to Customs (possibly even a copy of their acknowledgement) and that the vendor has registered for VAT. The evidence of date of completion will also be relevant on a subsequent sale by the mortgagor or mortgagee — see below.
Even if VAT is not payable on the purchase price, there are at least two situations (apart from the self-supply on developments discussed below) where VAT may become payable at a later date in respect of it. These may occur where the property has been bought under the VAT exemption for a transfer of a business as a going concern and is subsequently put to the use for the purposes of making exempt supplies (or for exempt lettings); or where the property has been bought as non-commercial or charitable and its use is changed. These situations must be borne in mind — the former in particular is an increasingly popular method of tax planning.
VAT refunds
A considerable variety of situations can arise regarding the right to a refund of VAT. Some lenders may be shy to finance the VAT component of the purchase price, on the basis that it can be recovered and is not a true outlay. Other lenders may provide short-term “bridging” finance for the VAT element of the purchase price, pending recovery of the VAT. In any event, the question of whether a company recovers VAT will, in the case of a substantial purchase, have repercussions for the borrower’s cash flow, and will affect the repayment programme. The same points arise equally with property developers who borrow to finance their development costs.
VAT paid by a business on the purchase of a property may be recovered only if it is attributable to taxable supplies made by the business. Thus, for example, if a company which makes only taxable supplies is to occupy the premises for its own business, the VAT will be recoverable in the normal way by a credit on the VAT return at the end of the relevant VAT month or quarter. However, recovery will be restricted where the business makes some taxable and some exempt supplies.
This is a complex area — fortunately outside the scope of this article — but the point for lenders is that it cannot safely be assumed that merely because a business appears to carry on a trade involving the making of taxable supplies, all its VAT on a purchase of premises will be recovered. The proportion of VAT recoverable may be distorted by many factors, for example HP or credit sales; or where the premises are occupied by a group holding, finance or property company which makes exempt supplies.
Where the purchaser is expected to use the premises for subletting, or is a newly established business, then it is especially likely that the VAT component of the purchase price will be a material factor and a lender may well be concerned to ensure that a recovery is made as soon as possible. In both cases, this will be possible only if the borrower is registered for VAT and, in the former case, where he himself elects to waive exemption on his sublettings.
If the lender is concerned with the VAT refund, then he may be content to allow matters to take their course (given that the borrower has an incentive to reduce his borrowings as early as possible) and to monitor cash flows which might, perhaps, be produced on the basis that the VAT recovery occurs promptly; or he can adopt a more “hands-on” approach by ensuring (perhaps through the borrower’s professional advisers or his own) that the borrower is registered for VAT, has elected if he needs to do so, or is otherwise able to recover the VAT — ensuring that any election is properly notified to Customs and, if the borrower is not already VAT registered, ensuring that he becomes so with effect from the completion date and procures a date for the quarterly or monthly VAT accounting period which ends as soon as possible after the completion date.
It should be noted that where the making of a supply is essential to enable VAT on the purchase price to be recovered, the VAT may not be recoverable unless there is actually a taxable supply of the land. If an exempt supply precedes a taxable supply (such as allowing a short-term tenant to occupy premises where no election has been made pending occupation by the group) the input tax on the purchase could be wholly disallowed. Customs may in practice not apply the full letter of the law and allow some types of exempt supply without denying the tax credit (eg advertising hoardings), but a written agreement should be sought. There is a case currently under appeal where the taxpayer is arguing that small-scale exempt supplies should not result in a total disallowance of the input tax. For the present, however, it may be appropriate to seek a covenant that no exempt supplies will be made with the land (and that a taxable supply will be).
Particularly where the loan is to “bridge” recovery of the VAT, the lender may well want some form of security over the right to recover the VAT. This may take the form of simply requiring the amounts to be paid into a separate account; a charge over the VAT refund; or an assignment of the right to the VAT refund. So far as a charge is concerned, it is accepted that a charge over book debts will include a right to recover VAT, but the lender should be aware that the “prior equities” which can arise include not only the normal ones but also the possibility that Customs could refuse to repay the VAT because of an earlier default in payment under section 21 of the Finance Act 1988.
Customs currently take the view that this provision applies even where a receivership intervenes before the VAT is recovered. Apart from this, it should be borne in mind that there may be doubts as to the legal effectiveness of an outright assignment (given that section 14(5) of the VAT Act 1983 provides for a payment of input tax to the taxable person and not to an assignee), and that in any event Customs are in practice unwilling to recognise the rights of an assignee and pay the refund direct to him for obvious administrative reasons — though in the case of banks this can be circumvented in practice.
Stamp duty
Lenders should also be aware that it is currently the Inland Revenue’s view that stamp duty is chargeable on the full VAT-inclusive cost of the land. There is some doubt as to whether this view is correct and at the time of writing there is some hope that provision will be made in the Finance Bill to relieve this additional charge; but the point must, for the time being, be taken into account in preparing costings.
The election to waive exemption
As previously noted, an advantage of the purchaser electing to waive exemption is that it enables him to recover input tax on the acquisition cost and other costs relating to the land. This does, however, have a knock-on effect for tenants or subsequent purchasers, since if they themselves make exempt supplies for VAT purposes they will be unable to recover the VAT. The same factors as are mentioned above will apply to tenants no less than they apply to any other purchaser of land who wishes to occupy it for his own purposes as described above. The commonest examples of businesses affected will be the banks, building societies and insurance companies. As is now well known, there has been some concern that this would result in a “two-tier market” in some areas where businesses which could not recover input tax would prefer to occupy premises completed before the change in VAT rules or where, because the landlord absorbed the input tax, they did not bear VAT on their rents. This, it was thought, would have an effect on the level of rents which could be obtained and thus on the valuation of the freehold. The writer’s impression, however, is that the effects have (except in a few particular areas) been less significant than was expected — so far. But it is early days.
None the less, the lender may well wish to ensure that an election to waive exemption is not made without his consent, and also that in applying any valuation formula to the security the possible effects of the election being made are taken into account.
“Self-supply” on completed commercial developments
Because of the transitional reliefs in the 1989 legislation, and the opportunity taken by many companies to pre-pay their development expenditure, the full impact of the VAT charge on completed commercial buildings has not yet been felt. The writer is not, in fact, aware of any instance where it has yet been paid, despite inquiry among other VAT advisers. It is, however, potentially very expensive and lenders will need to be alert to the possibility of its arising in the future.
The charge will result in VAT becoming payable on the purchase price of the land and the costs of development (by whomsoever incurred). The charge will arise only in certain circumstances, broadly on the first occasion where within 10 years of completion a person who has been a “developer” in relation to land grants an interest in it (ie sells it or grants a lease or licence) which is an exempt supply or where he occupies it himself and uses it for the purposes of a business carried on by him or a member of his VAT group which does not consist wholly in the making of taxable supplies. There is a de minimis exemption of £100,000.
The persons who are within the charge as “developers” include any person who constructs the building, who “orders it to be constructed” or who “finances its construction” “with a view to granting an interest in, right over or licence to occupy” the building or to occupying or using it or any part of it. This is less than clearly drafted, but it seems that a lender will not itself be subject to the self-supply as a person who finances the construction, unless it itself acquires an interest in the land or proposes to occupy or use any part of the completed building for its own purposes. It is not considered that the provisions in a standard mortgage (eg power of sale) count as “using” for this purpose.
The legislation does not provide for any order of priority between the persons potentially subject to the charge, and it seems that any one of them may be charged if another of them actually makes the exempt supply of the land or occupies it for exempt purposes as described above. This means that the amount of the charge will vary according to the cost of the property of the taxpayer in question. Although Customs have said that they are content to accept that the parties may agree among themselves which of them should make the payment, they have not denied in discussions that they wish to retain the right to go against other persons who are “developers” where the person agreed upon fails to pay the tax or becomes insolvent.
The ramifications of this are likely to be serious, but there are two points which clearly emerge. The first is that where the building has been developed with a view to subletting, the persons who are developers should all elect to waive exemption, in which case (provided none of them then occupies the premises for their own exempt business) no self-supply tax charge is likely to arise. The second point is that all lenders to property developments will need to look very carefully at the structure to be sure that their borrowers cannot be caught by a tax charge if the person intended to pay fails to do so.
There are no special rules affecting the recovery of VAT chargeable on a borrower under a self-supply. Thus, a fixed charge will normally have priority over the tax, but if the charge arises within six months of the “relevant date” (as defined by section 387 of the Insolvency Act 1986) in an administrative receivership or liquidation it will be a preferential debt.
Realising the security
On a disposal of commercial land, VAT may be chargeable by the borrower (or any receiver or liquidator) either because the building is still a newly completed building or because the election to waive exemption has been made. The election, once made, is irrevocable and will apply not only to the company but also to any receiver who sells as agent of the company. Since a sale under a power of sale is treated under para 6 of Schedule 2 to the VAT Act 1983, as a supply by the taxable person, it seems, though the position is less clear, that the same may apply to a sale by a receiver who is not an agent of the company and to a sale by a mortgagee in possession as well as to a receiver appointed under a fixed charge.
A mortgagee in possession or other person selling under a power of sale must himself account for VAT under Regulation 59 of the VAT (General) Regulations 1985 and send the person whose goods were sold a copy of the statement which he is required to provide to Customs. There is no automatic charge on administrators or administrative receivers, but as Customs have power to register them and make them accountable for VAT personally, they in practice account for VAT also. So far as a sale by the company itself is concerned, the obligation to account for VAT does not arise until the end of the relevant quarter. Thus a failure to account for VAT could result in a personal VAT liability on a receiver or administrator, or a VAT liability falling to be met by a mortgagee. The company could in theory account to the lender for the VAT element, but where the company does not have other funds available to meet the tax it must be borne in mind that the VAT may in appropriate cases be a preferential debt in a subsequent insolvency and the implications of the Insolvency Act 1986 must also be borne in mind.
There are also complications about VAT invoices when the security is realised. No purchaser properly advised will complete without a valid VAT invoice if he has to pay VAT and wishes to recover the tax. It should be borne in mind that the statement required under Regulation 59 above is not a normal VAT invoice but is given on a special form (one occasionally difficult to locate at local VAT offices). In other cases, an administrative receiver can, as agent for the company, issue a VAT invoice in the usual way.
