Value added tax was introduced in the UK in 1973 to replace purchase tax as a consequence of Britain’s EC membership. It is imposed on the supply of goods and services and is intended, principally, to be a tax levied on the final consumer. In the past the tax had comparatively little impact on the property markets and the majority of surveyors could probably expect to get by with no more than a passing knowledge, it being sufficient to recognise the need to add VAT to fee invoices and to allow for VAT on fees, where appropriate, in residual and other valuations. Unfortunately, with recent changes imposed on the Government by the European Community, this is no longer the case.
Like many taxes VAT is comparatively simple in outline, but extremely complex in application. It is therefore essential to understand the main principles involved to appreciate fully the effect of the tax on any particular transaction.
The major current legislation is the VAT Act 1983, as amended by subsequent Finance Acts, and section 2 of the Act states that VAT “shall be charged on any supply of goods and services made in the United Kingdom, where it is a taxable supply made by a taxable person in the course or furtherance of any business carried on by him”.
A taxable supply is any supply of goods and services other than a supply which is specifically exempt from VAT. Such a supply will be subject to the standard rate of tax (standard rated) unless it is otherwise defined as zero rated. A taxable person is one who makes taxable supplies while he is required to be registered.
VAT is applied to businesses and the definition of business for this purpose is quite wide in that it includes any trade, profession or vocation, but also includes the provision of facilities by clubs and associations.
All businesses, with the exception of those which are very small, have to be registered for VAT purposes and are required to make returns to Customs & Excise. Small businesses which are not registered are not required to charge VAT on goods and services supplied, but equally cannot reclaim any VAT on goods and services supplied to them.
After the end of each accounting period, normally three months, businesses are required to make a return to Customs & Excise specifying all their “outputs”. These are all goods and services supplied by them to other businesses and consumers. At the same time businesses are allowed a credit for VAT on “inputs” during this period. Inputs are the goods and services supplied to the business. The balance payable to Customs & Excise for the period will be the amount by which VAT charged on outputs exceeds the VAT paid by the business on its inputs. In this way the incidence of VAT is passed down the chain of supply and ultimately settles on the final consumer, who, not being a business and having no outputs, is unable to reclaim the VAT paid on goods and services supplied to him.
The standard rate of tax is now 17.5%, but not all inputs and outputs are taxed at this rate. Certain types of supply are treated specially by being either exempt from VAT or by being zero rated. This distinction is critical and it is this which gives rise to much of the difficulty in understanding the implications of the tax in the context of property transactions.
Zero rating and exemption
The supply of goods and services, which is zero rated, is notionally taxed at 0%. This means that no tax is charged on the supply (output), but full credit is given to the supplier for all tax paid in respect of inputs. Thus a supplier of predominantly zero-rated goods is likely to have more tax on inputs than outputs and will be able to claim back the difference from Customs & Excise. Zero-rated items are grouped together and identified in the Customs & Excise VAT Leaflet 701/39/90. These include food (with some exceptions such as confectionery), sewerage services and water supply, books and newspapers, fuel and power for domestic use, passenger transport, drugs and medicines on prescription, sales of donated goods in charity shops and children’s clothing and footwear.
Exemption, ironically, is an altogether less favourable treatment. Supplies of exempt goods and services attract no VAT, but, at the same time, no credit is allowed on any VAT paid in respect of the inputs of the business. Thus businesses supplying exempt goods and services upon which no VAT is charged have no means of reclaiming tax paid on inputs, so that the incidence of the tax cannot be passed on as is the case with zero-rated supplies. Difficulties clearly arise in the case of any business that supplies both taxable and exempt goods and services because it is necessary to distinguish, in identifying the credit for tax on inputs, between those which are used for exempt and non-exempt supplies. This is known as a partly exempt business. The major areas of exempt supply include land, insurance, postal services, betting, finance, education, health and burial. Again these are identified in full detail in VAT leaflet 701.
The changes
VAT is essentially a European tax. Member countries are free to determine their own rates of tax, but, to ensure fair treatment between EC countries, it is considered to be important that types of goods and services are treated similarly with regard to the type of charge imposed in different EC countries. This requirement towards harmonisation has led to a number of important changes, particularly in respect of the treatment for VAT purposes of transactions concerning land and buildings. These changes arose as a result of the decision in the European Court of Justice in Commission of the European Communities v UK June 1988.
In accordance with EC law, zero rating can be applied only “for clearly defined social reasons and for the benefit of the final consumer”. The essence of the judgment was that, while this principle could be applied to the domestic sector of construction and land supplies, it should not apply to the non-domestic sector. As a result, the Government was forced to introduce major changes in the application of VAT in these areas by the Finance Act 1989 which became effective principally, on April 1 1989.
Prior to 1989 zero rating applied to items in group 8 in Schedule 5 to the VAT Act 1983 which included the granting of a major interest in a building by the person constructing the building, the supply during construction of any services other than architect, surveyor or other person acting as a consultant, the supply of materials for the construction of any building, the granting of a major interest in a substantially reconstructed protected building and the supply of services in the course of an approved alteration to a protected building (other than architect, surveyor or consultant). A major interest is defined as a fee simple or a lease for a term certain exceeding 21 years.
Typically then the sale of the freehold interest in a building by the freeholder, or the granting of a lease of over 21 years, were zero rated so that the freeholder disposing of the interest could recover any input VAT incurred in construction.
In outline the position now is as follows. The sale and leasing of used domestic and non-domestic buildings, leases of new domestic buildings and the sale of building land for domestic building are all exempt. Zero rating applies to the following two categories: sales of new domestic buildings where the seller is the person constructing the building, and leases of new domestic buildings where the lease is capable of exceeding 21 years. All other types of land and building transactions are standard rated. The changes are outlined in the following table.
The option to tax
Thus from April 1 1989 many land and property supplies became exempt as opposed to zero rated. As a consequence VAT on expenses and construction costs would have been irrecoverable by a landowner or developer letting a building after that date. This position has been substantially modified by a concession which allows suppliers the right to charge tax on certain transactions by exercising an option to waive the exemption — resulting in the supply being standard rated.
This option may be exercised separately in respect of each individual building in a supplier’s ownership and may be made at any time, allowing VAT to be charged on transactions which would otherwise be exempt. Once exercised, though, the option is irrevocable and will apply to all transactions in respect of that building. Exercising the option to tax effectively turns an exempt supply into a standard-rated one. The important effect of exercising the option is to make any input tax recoverable.
It is interesting that the option to tax does not require consultation with the person to whom supplies are made and to whom the tax burden will be passed on, even though, in the case of tenants, this may have a significant influence on the amount of rent which they will have to pay. This will not be a problem for tenants who themselves are fully taxable for VAT purposes because they will be able to recover the extra charge as input tax. However, where the tenant is exempt or partially exempt this will not be possible and the tenant will have to bear the extra charge. The major category of exempt tenants is that of financial institutions, which include banks and building societies, insurance companies, securities houses and hire purchase companies, and their inability to recover VAT on inputs may result in depressing the rental values of properties which they occupy.
As the election has to be made for a building as a whole, difficulties may arise in the case of buildings which are let to more than one tenant, where one is exempt and others are not. In determining whether to make the election, it is important for the landlord to establish the tax status of tenants or possible tenants. This is important as not only is the election irrevocable and must apply to all leases granted within that building but also any subsequent sale of the building will have to be standard rated.
Self supply
This is a VAT charge on businesses which carry out their own building work and is an anti-avoidance measure. A deemed VAT charge is raised on the completed development, including the cost of the land. This arises in the case of non-residential buildings where there is an exempt supply, that is where the building is let with no option to tax or the building is occupied by a person not making wholly taxable supplies.
On the completion of new buildings where there is an exempt supply, there is a deemed supply of the developer’s interest in the land to himself and VAT is charged on the transaction; furthermore, this will be unrecoverable. The deemed consideration is the cost of the land and the building works. This rule does not apply where the aggregate cost is less than £100,000, but will affect development by exempt suppliers such as banks, insurance companies, schools, doctors etc in developing buildings for their own use, as well as developers who intend to sell or let without opting to tax. In such cases the VAT imposed will increase the cost of the development.
Effect of the changes
Prior to April 1989 the sale of a freehold interest in a commercial building was an exempt supply unless the freeholder had built the building, in which case it was zero rated. Now all sales are exempt, unless it is the sale of a new building which is defined as a sale within three years of the completion or occupation of the new building, whichever is the earlier, where the sale will be standard rated. In the case of a standard-rated sale the purchaser will recover the VAT if he is not an exempt supplier and the building is occupied for the purpose of business activities. Investors will recover input VAT if they opt to tax the rents on the letting of the property. The input VAT will normally be the VAT charged on professional fees in relation to the sale unless the vendor has paid for the construction of the building or has spent large sums of money on improvement and repairs. If the VAT input is considerable and the purchaser cannot recover the VAT this may have a considerable bearing on the purchase price. Where the vendor has already exercised an option to tax the rents of the building, then any subsequent sale must also be standard rated, although a new owner would be entitled to decide afresh whether to exercise the option.
Prior to April 1989 the disposal of a leasehold interest was an exempt supply. Now the vendor of the lease can opt to treat a sale or assignment as a standard-rated supply. In the case of mixed commercial and residential buildings the sale would need to be apportioned between the residential element, which would be zero rated, and the commercial element, which would be standard rated or exempt.
The sale of new residential property is zero rated, so that housebuilders will not charge VAT on the sale but will be able to recover input VAT on agents’ and solicitors’ fees. All other supplies will have been zero rated anyway. As secondhand residential sales will normally be to private owner-occupiers who are not registered for VAT, few complications will arise with this category of transaction.
Prior to 1989 the grant of a lease was an exempt supply unless it was a lease for more than 21 years in respect of a building constructed by the landlord. Now the grant of any lease is an exempt supply, but the landlord has the option to tax. In deciding whether to waive the exemption it is necessary to consider how much VAT will be recovered against any depreciating effect on the rent offered by the tenant as a consequence of his inability to recover the additional charge.
The letting of a residential property is an exempt supply with no power to elect to tax. Lettings for more than 21 years and lettings of listed residential buildings will be zero rated.
In the case of most leases the VAT inputs will be limited to items such as management and valuation fees. It is only where the landlord has significant involvement in repairs or improvements that input VAT is likely to be a major item.
The sale of bare land by an owner will be an exempt supply, but, with the exception of land for residential development, the owner may elect to treat the sale as standard rated. If infrastructure has been provided the sale may be treated as a standard-rated supply, as civil engineering works are standard rated and part or all of the proceeds of the sale are attributable to them. This is, of course, a matter of degree.
New development is now a standard-rated supply. In the case of construction beginning after August 1 1989, the developer is subject to the deemed self-supply rules. On completion of the building the developer is assumed to make a taxable supply so that input VAT on construction costs is recoverable as the development proceeds. Where the developer is building for his own use, after April 1989 he is deemed to make a supply to himself of the building work at its then market value.
Development of existing buildings, conversion, reconstruction, alteration or enlargement from August 1 1989 is subject to an option to tax, so that VAT on building costs can be recovered.
Where the sale of a new building takes place within three years of completion the sale will be standard rated. If the sale takes place after three years it is exempt with an option to tax.
As a consequence of the new rules, in particular the option to tax, advisers in the majority of property transactions will now need to give more careful consideration to the question of VAT. Generally speaking, where the option is available, most landlords would opt to waive the exemption to be able to recover any input tax. However, there will be cases where this advantage is outweighed by the depreciation in rent or sale price which is the consequence of the inability of exempt tenants or purchasers to pass on the tax. In all cases where the option is available, it is necessary to have regard to the tax status of actual and prospective tenants and purchasers. Furthermore, advisers will have to consider VAT as a significant element in the drafting of leases and rent review clauses. Where rent review clauses make reference to the hypothetical parties to the transaction it may be necessary to clarify, in the case of the hypothetical landlord, whether they are assumed to have elected to waive the exemption, and in the case of hypothetical tenants, whether they are assumed to be standard or zero rated or exempt suppliers. In the drafting of leases tenants may seek to prevent the landlord from opting to tax without the consent of the tenant.
Clearly, then, in all cases where advice is being given to either party in a whole range of property transactions, the effect of VAT is yet another aspect which needs to be considered.
