by John Moore and Amanda Lawrence
On August 1, a new element was introduced into the twilight world of VAT on property, an element novel to any tax system — the taxpayer was actually given a choice of whether or not to pay tax. This is a disturbing development; property people have not had to think much about VAT until now, but as taxpayers they are used to facing new taxes with fortitude, taking advice on legitimate avoidance tactics and otherwise accepting the inevitable. They are not used to having a choice in the matter. In the case of VAT, however, the Government has apparently put the ball in the taxpayer’s court. A choice faces all those who make VAT-exempt supplies of commercial property, a choice which could have a considerable impact on their whole VAT status. It is, moreover, a choice which needs to be made before October 31 to get the maximum benefit. This article considers how you should go about making the choice, what is actually happening in the market — and how much of a choice is it anyway?
The right to elect for taxation on supplies of land (alias “the option to tax” or, more properly, the right to waive exemption) was a kind of quid pro quo for the forced abolition of zero-rating on commercial property. Zero-rating was a useful benefit which allowed the supplier to offset input tax against outputs to which he did not actually have to add VAT. After April 1, as the property world now knows, all supplies of commercial property became either standard-rated or exempt. VAT was imposed on some transactions that had not previously suffered it, while others became non-taxable and therefore ineligible for the supplier to reclaim his input tax in relation to them. However, with the changes in VAT status came the option to tax, which enables the VAT-registered supplier to turn an exempt supply into a standard-rated one. He then has to account to Customs & Excise for the 15% of the price, but he can pass this cost on to the recipient of the supply and he can now reclaim any input tax which relates to the supply. The right to elect became operative on August 1, and for the election to be deemed effective from that date it must be exercised by October 31.
It is important to make the right choice about the option to tax. What are the questions the property investor should be asking himself?
(1) Does the option to tax apply to this transaction?
The option to tax applies to transactions which are exempt supplies of land for VAT purposes. As from April 1, most grants of an interest in, right over or licence to occupy land are exempt. This includes, most importantly, the grant of a new lease, payments of rent on an existing lease, the freehold sale of a building completed before April 1 or one completed subsequently when it is more than three years old, and the freehold or leasehold sale of building land. It also includes the grant of a specific right of way or similar right, and the grant of a licence to occupy.
There are some important exceptions. Not included are the freehold sale of a building completed after April 1 while it is less than three years old, the surrender of a lease, or any one of a number of specific exceptions listed in Group 1 of schedule 6 of the Value Added Tax Act 1983, all of which are standard-rated. The specific exceptions include hotel accommodation, caravan sites, parking rights, sports facilities and the like. The other important exception is residential property, which remains zero-rated and therefore ineligible for the option to tax. This includes any part of a building which is used for residential purposes, even if the building is principally used for business purposes.
Clearly, owners of buildings which are already let, as well as those who plan to grant leases or sell land or buildings, may want to elect to add VAT to rents or sale prices.
(2) Am I the person who has the right to opt to tax?
The option is exercisable by any person with an interest in the building in respect of which he makes supplies for VAT purposes. Therefore, if the building is owned by freeholder A, let to head lessee B, and sublet to sublessee C, A and B have separate rights to opt to tax the headlease and underlease respectively.
(3) If I do opt to tax, how will the election operate?
The election is personal and irrevocable. For example, once the owner of a particular building has opted to tax a lease of the building, he must tax every lease or other supply made in relation to that building during his period of ownership. However, if he assigns the reversion of the building, the new owner can make his own election. Only if the existing building is completely demolished and a new building erected on the site is the owner released from his election on the previous building.
The election can be exercised in several different ways. The owner can make a separate election for each building or plot owned, except where agricultural land is concerned. Alternatively, he can elect for all buildings or land of a specified description. Or he can elect for all land and buildings owned. If he owns agricultural land, he must make one election for all the land, except where different farms are separated by non-agricultural land or land in different ownership. In that case, he has a separate right of election for each individual unit.
One other rule affects the basis of election: this is the notorious “covered walkway” rule. Buildings linked internally or by covered walkways, parades, precincts and complexes split into separate units are treated as one unit for which the owner has only one right of election.
(4) What are the advantages of opting to tax?
This and the next question are the most important for the property investor. Normally there will be an advantage in opting to tax, but this is not always the case.
The principal advantage of exercising the option is that it increases recovery of input tax. Any input tax referable to that building or land can be recovered. If the owner has already incurred, or will incur, a significant amount of VAT, he will benefit from opting to tax. This will arise where, for example, a refurbishment has been carried out, or where significant repair or improvement bills are envisaged for the future.
Furthermore, a business which is otherwise wholly or partially exempt can improve its overall VAT position by, for example, opting to tax the rent on all buildings it owns. Broadly speaking, a business which makes exempt supplies can recover only so much of its input tax as is equivalent to the proportion of taxable supplies it makes overall. Consequently, the more taxable supplies the business makes, the higher the proportion of its overall input tax that can be recovered.
The business may be able to secure a cashflow advantage if its VAT accounting period can be so arranged that it does not have to account to Customs & Excise for the VAT until after the taxed payment has been recovered.
Another reason for exercising the election is if the developer of a new building, or the investor funding it, plans to grant leases of the building rather than sell it. In this case, opting to tax the leases is essential to avoid the self-supply charge which applies as soon as an exempt supply or exempt occupation of the building takes place. The developer/investor will need to weigh up the disadvantages (if any) of exercising the election against the likely VAT bill if the self-supply charge operates.
(5) What, then, are the possible disadvantages?
The owner of land or buildings can opt to tax supplies of the land or buildings without consulting the person to whom the supplies are to be made, and to whom he will obviously be passing on the tax burden. In particular, a landlord need not consult his tenants before opting to tax their leases. For the tenants, no difficulty will arise provided they are themselves fully taxable for VAT purposes and can recover the extra charge as input tax. If, however, a tenant is exempt or partly exempt, he will not be able to recover the tax. This does not stop the landlord from exercising the option — but remember that once the option has been exercised it is irrevocable. If the situation of the building or its particular design make it likely to attract only exempt or partly exempt tenants (for example, a building designed as a banking hall in an area traditionally dominated by financial institutions) then the effect of opting to tax may be to depress the rental value. Likewise, opting to tax building land could depress its sale value.
Since the election must be exercised for a whole building, it is not possible to make an exception for one or two exempt tenants where the others are all fully taxable. However, there are some possible alternatives. In return for not opting to tax, the landlord could agree a higher rental with the tenant, or some other form of compensation, to offset the landlord’s irrecoverable input tax.
From a practical point of view, therefore, it is important to know the VAT status of your tenant/purchaser (or whoever), and that of any likely future tenants before exercising the option.
As the answers to questions 4 and 5 show, the decision whether to opt to tax is something of a balancing act between several different considerations. While there is an inherent risk in generalising, the most significant factors are summarised in the following checklist:
(1) If you opt to tax, you will be entitled to recover any VAT paid by you in relation to the building.
(2) Once an election has been made, it is irrevocable while the property remains in your ownership, and will affect all leases granted by you within that building.
(3) If you elect, any subsequent sale of the property will be standard-rated.
(4) Remember that, on a sale of a standard-rated building, stamp duty will be payable by your purchaser on the price of land plus the amount of the VAT.
(5) If you are constructing a new building you will need to make an election by the time of the grant of the lease or occupation of the building if you are to avoid the self-supply charge.
(6) Are you likely to incur significant amounts of VAT on improvements, general management, legal fees or repairs, which you wish to be able to recover?
(7) Can your tenant recover the VAT he will have to pay?
(8) What effect, if any, will an election have on the rent review, or on the investment value of your building?
(9) If you are partially exempt — for example, if you are an insurance company — an election will improve your overall ability to recover VAT. However, you should bear in mind that though this might help the company, it should not be at the expense of the policy holders.
(6) Do I really have a choice?
From the foregoing, it will be obvious that in many cases the choice to elect will be dictated by financial and other circumstances. Consider, for example, our building owned by A, let to B and sublet to C. A needs to elect to tax B’s rent because he is the developer of the building and will otherwise incur a large self-supply charge. B is fully taxable, but C is partially-exempt. B has no choice but to elect to tax C’s sublease because he needs to pass on the VAT imposed on him by A.
In the majority of cases, the best course will be to make the election. This, of course, is what is intended by the Government! The choice is not so much of a choice as all that.
(7) When should I elect?
The simple answer to that is “as soon as possible”. The election is not retrospective. In general, VAT cannot be added to a transaction until the election has been made, and no input tax incurred before the first day for which the election has effect can be reclaimed. However, between August 1 and October 31 a period of grace has been decreed. Elections made within this period can take effect from August 1. If input tax incurred in the transitional period between April 1 and August 1 is to be recovered, it is vital that an election having effect from August 1 is in place. As the election must be notified to Customs & Excise within 30 days, in practice property owners have until November 30 to notify Customs that an election has been made with effect from August 1.
(8) How do I make the election?
The practicalities of making the election are quite straightforward. Having decided on what basis he is going to elect (building-by-building, specified land or all land/buildings owned) the person making the election must notify Customs & Excise in writing within 30 days, unless the total consideration for all supplies for the buildings/land for which the election has been exercised is expected to be less than £20,000 in the next 12 months.
There is no standard form for notifying Customs of the election. All that is required is a letter to the local VAT office giving the following:
name and address,
VAT registration number,
specifying the land or buildings, or the description of land or buildings, for which the election is being exercised.
It is easy enough for bystanders to talk about how the decision to elect should be made. But what is actually happening in the market-place? A survey of 151 property investors, comprising banks, pension funds, insurance companies and property investment companies reveals some interesting trends. Those who took part were asked about their intentions as regards opting to tax their portfolios.
(1) Of those who have or will be electing, 90% are doing so building by building, and by no means across the board. Many have elected on some properties already but are keeping their options open on others.
(2) Only slightly more investors have already elected than those who have not, and those who have not are evenly divided between those who do plan to do so in the future and those who do not. The result is that by the end of October a majority of investors are likely to have elected on at least part of their portfolio.
(3) Although the majority of investors will have elected by the end of October there is no sign of a general rush to do so across the board. As one respondent put it: “It would make commercial sense [to elect before October 31] but we may prefer to keep the option.”
(4) Most of those who are or will be electing are obviously thinking carefully about the basis on which they will elect, and only doing so where there is a clear financial advantage. Several say they will elect where money has been spent (on new development or on refurbs) the VAT on which can be reclaimed, ie, the general trend is to make the decision on an individual basis, after consideration.
(5) Agricultural landowners do not appear to be keen to exercise the election for their agricultural land. Specific comments made in replies about the basis of election were:
“where new build/refurb”
“only if financially worthwhile”
“on recently developed portfolios where VAT on building costs can be recovered and cashflow advantage obtained”
“where money spent on refurbs and premiums”
“on the whole retail/industrial portfolio and a few office buildings where there is a clear benefit”
“probably on developments only”
“new build or substantial refurb”
Therefore, opting to tax future supplies of the property is most likely to be beneficial, although it may also present problems. Either way, it is not a decision you can ignore.
