by Dominic Taylor
An alarming amount of time seems to be spent these days on disputes over the relatively simple matter of how to treat the VAT element of costs paid by the tenant for the landlord. Confusion in this area stems partly from changes in practice brought about by the 1989 legislation on VAT and property, and partly from an understandable unwillingness on the part of practitioners to bend their minds to the illogicalities of VAT. The problem has been aggravated by the potential exposure on errors to penalty interest charges since the implementation of that part of the VAT civil penalty regime on April 1 1990. However, if some basic principles of VAT are understood, and the guidance given by Customs & Excise on the subject is accepted, no dispute should arise over what practice should be followed.
The theory
The first principle of VAT to be remembered is that VAT on costs can be recovered as input tax from Customs & Excise only by the person to whom the supply of services has been made, and then only if that person incurred the cost in the course of himself making a taxable supply. This means that, in the simple case of a VAT registered tenant who pays the legal costs of the landlord, the tenant cannot claim in his VAT return for the tax element of the landlord’s costs, and the landlord can recover the VAT only if he has elected to charge VAT on the rent or premium which he receives for the lease (or, in exceptional circumstances, if the lease is zero-rated).
The second principle is that the payment of costs can be consideration for a supply made to the payer by the person on whose behalf the payment is made. The payment then comprises the value, or part of the value, for VAT of that supply.
Thus, where the landlord is granting a lease to the tenant, the tenant’s payment of legal costs is part of the consideration for that grant. If the landlord has elected to waive exemption, he must account for VAT on this additional value as well as the underlying rent or premium.
Last (and logically!), if there is no supply of services, no charge of VAT arises purely as a result of making the payment. This is not quite so straightforward as it may at first appear because Customs & Excise seldom believe that anyone will pay something for nothing, and they have a wide power to deem a supply where it appears that consideration has been given. None the less, the principle is good and has an application to some costs paid by tenants.
Customs & Excise apply all these principles in the advice which they give on “Indemnities under property lease arrangements” — para 15, VAT Notice 742B. In the notice, Customs say:
(i) any payment a prospective tenant makes to obtain a lease is part-consideration for the grant;
(ii) if a tenant makes a payment to (or on behalf of) his landlord to obtain some additional right, it is consideration for a supply separate from the lease and is normally standard-rated;
(iii) if a tenant makes good the costs of his landlord resulting from his exercise of existing rights, that payment is not consideration for any separate supply by the landlord to the tenant; and
(iv) any VAT charged by the landlord’s advisers relates to their supply of services to the landlord, and the tenant cannot deduct it as input tax even though he bears the costs.
The practice
In practice, the VAT treatment of landlord’s costs paid by a tenant can be divided into three broad categories.
Prospective tenants
A payment made by a prospective tenant to indemnify a landlord for his costs is regarded as part of the consideration for the grant of the interest in the property. The amount paid by the tenant therefore represents part of the value of the supply made by the landlord to the tenant.
If the rent or premium is exempt from VAT, the landlord will not be able to recover as input tax the VAT on his costs and he will require the tenant to pay the gross costs including the VAT element. The tenant will not receive a VAT invoice from the landlord or the advisers of the landlord because no taxable supply has been made to him. Therefore, even though the tenant has paid VAT for the landlord, he cannot recover it as input tax.
If the landlord has elected to waive exemption, and charges VAT to the tenant on the rent or premium, he will be able to recover as input tax the VAT charged to him by his advisers. He will then require reimbursement from the tenant only for the net amount of his costs but, since it represents part of the value of his taxable supply to the tenant of the interest in the property, the landlord will himself add a charge of VAT to that net amount.
The tenant will therefore pay the same amount in total as he would if the rent were exempt, but he will receive a tax invoice from the landlord (not the landlord’s solicitors, who will issue their VAT invoice to the landlord), allowing him the opportunity to recover the VAT element as input tax if he has taxable status.
Existing tenants — exercise of rights
A tenant may be required by his lease to indemnify the landlord for costs incurred when he exercises a right granted to him under the terms of the lease, for instance to assign, sublet or make alterations.
Such a payment made by the tenant is agreed by Customs & Excise not to be consideration for any supply made by the landlord to the tenant. There is therefore no supply to which value can be ascribed, and the payment has no effect on the VAT position of either the landlord or the tenant.
If the landlord has elected to waive exemption, he will be able to deduct as input tax the VAT on his costs. He may then require the tenant to indemnify him only for his costs net of that recovered VAT. If the landlord has not made an election, he will not be able to recover VAT and will accordingly require the tenant to pay the VAT inclusive amount of his costs.
In either case the landlord will not issue a tax invoice to the tenant, and he should not do so because such a charge of VAT would be invalid.
Existing tenants — additional rights
A tenant may make a payment to his landlord to obtain a right which is not within the terms of his lease, for instance to assign or sublet where such action is expressly forbidden. That payment is consideration for a taxable supply of services (a right separate from the lease) on the value of which VAT is chargeable at the standard rate. That liability to VAT exists regardless of whether the landlord has elected to waive exemption in respect of the lease.
However, if the landlord is not registered for VAT (because he makes no other taxable supplies) no VAT charge will actually arise on this payment. It is interesting to note that if the costs are sufficiently large the reimbursement by the tenant may render the landlord registrable for VAT because his taxable turnover then exceeds the registration threshold.
If he has taxable status, the landlord will be required to issue a tax invoice to the tenant. Since he is making a taxable supply, he should be able to recover the VAT on his costs and accordingly the value on which he charges tax to the tenant should be the net value of his costs. (The landlord will have been issued with a tax invoice by his solicitors for their fees.)
Finally, a few words about the arrangements for actual payment. Frequently, the tenant will ask or be asked to make payment direct to the landlord’s advisers, whose fees he is paying. This may be acceptable, provided that the full invoice procedure is followed, but under no circumstances should the VAT element be netted off. It is clear from the examples illustrated in this article that only in one instance does the payment by the tenant not include an element of VAT. Whether that tax is a cost to the tenant or not depends upon whether he can recover it as input tax, and not upon the recovery position of any other party to the arrangement.
