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While looking at the ever-changing Manchester skyline, it occurred to me that how VAT applies to property transactions is probably the single area of VAT on which we provide the most advice.
VAT and property isn’t just something that developers and investors have to concern themselves with though, it is something that affects almost all businesses to some extent, since most businesses are connected in some way to at least one property.
It is an area that has evolved significantly since the 1980s as HMRC have tried to keep up with the rapid development of both commercial and residential property sectors, not least the innovative ways in which developers have found alternative uses for existing buildings that would otherwise have passed their sell-by date. As is so often the case, Manchester has been at the forefront of this.
This brings me onto the topic of this article: How changes in the use of land or buildings can have unexpected VAT consequences for the unwary.
One of the significant changes that HMRC introduced in the 1980s that is still with us today, is the VAT Capital Goods Scheme (the ‘CGS’) and it is this I’d like to talk about.
The CGS is a VAT accounting mechanism under which the use of certain high value property assets must be reviewed over a longer period (usually 10 years). If the use of the property changes in that period, there may be a requirement to repay to HMRC some of the VAT that had originally been recovered, or conversely, an additional VAT refund may arise, depending on how the use has changed.
When I talk about change of use, I mean the extent to which the property is used to carry out VATable transactions. Most businesses’ core activities only involve carrying out VATable transactions, so if they do nothing else, there is unlikely to be any requirement to make a CGS adjustment.
Of course, there are many businesses that do carry out non-VATable activities on a regular basis, and these businesses should be particularly aware of the potential impact of the CGS.
However, it is often non-core or exceptional transactions that catch businesses out and these transactions often involve the grant or transfer of an interest in the property (i.e. sale or lease transactions).
Typically, when a business incurs VAT costs, it recovers the VAT in accordance with how the costs are used in the business. If the costs are used in carrying out transactions that are subject to VAT (including zero-rated transactions), the VAT can be recovered. If not, they cannot normally be recovered. If the costs are used in carrying out both taxable and non-taxable transactions, partial VAT recovery is usually appropriate, and a partial exemption VAT recovery method will need to be used.
This is normally dealt at the time the costs are incurred and once a new ‘VAT year’ begins, a line is drawn and there is no need to revisit the treatment of these VAT costs again.
However, if VAT has been incurred on the acquisition, lease, extension, renovation, refurbishment or other significant works relating to land and property, and the VAT exclusive cost exceeds £250k, the use of the asset must be reviewed over a 10 year period, typically starting from the period in which the asset was first occupied or used.
The £250k threshold has been in place since the CGS was introduced in the 80s and has not changed since. The impact of this is that although the CGS may have originally been designed to apply to a relatively small number of high-value developments (cough, Canary Wharf, cough) the reality now is that an increasing number of ‘regular’ property transactions fall within its grasp.
This is perhaps one of the reasons why the CGS is an area of VAT that remains unfamiliar to many taxpayers and their advisors, considering the number of assets that it potentially applies to.
Where the use of land or buildings does not change, there will be no requirement to make a CGS adjustment.
So, for example, if a Company recovered £2m VAT on the acquisition of its £10m head office in March 2015 and continues to use it solely to run its 100% VATable business, does not carry out any other activities from the property and does not grant any interests in the property, the CGS period will expire in March 2025 with no need to make any CGS adjustments.
If the same Company starts to provide not-VATable services (e.g. financial services) from the property during 2020/21, there may be a requirement under the CGS to pay back (at the end of 2020/21) some of the £2m VAT originally recovered, because the property is no longer used for a 100% VATable purpose. The amount paid back to HMRC will depend on the extent to which the use changes, but the partial exemption method used to calculate VAT recovery in the year in which a CGS adjustment is due will normally be used to calculate the change of use. If the non-VATable activity continues in future years, further CGS adjustments may be required until the CGS period expires.
However, the scenario under which a CGS adjustment is more likely to arise in our experience is where a sale or lease of the property (or part of the property) occurs within the 10-year CGS period. The impact is likely to be greater if a CGS property is sold, because when a CGS asset is sold, the CGS ‘crystallises’, and a single adjustment is made, essentially an aggregate of all remaining CGS periods, with the ‘use’ of the asset in all remaining periods treated as being the same as the VAT treatment applied to the sale (either VAT exempt or VATable).
If the sale or lease is subject to VAT (because an option to tax has been made) a CGS clawback is not likely to arise, although a further VAT refund may be possible if there had been a restriction to VAT recovery when the cost of the CGS asset was first incurred.
However, if the sale or lease is VAT exempt, there is likely to be a VAT clawback, particularly if the VAT originally incurred on the cost of the CGS asset was fully recovered.
The CGS can be a complex matter to manage, but is a mechanism that taxpayers and their advisors should be aware of so that the pitfalls described above can be avoided wherever possible.
For example, I have encountered many situations where, when a sale or lease is envisaged, the taxpayer or their advisor had thought that it would only be the recovery of VAT on sale/lease costs that might be restricted if the sale or lease was VAT exempt, not being aware of potential CGS adjustments.
A VAT exempt sale or lease may be desirable if the only impact was the loss of a relatively small amount of VAT on related costs, but additional CGS costs might make a VAT exempt sale or lease much less palatable.
If potential CGS adjustments are envisaged, they may be avoided by opting to tax the land or buildings so that the sale or lease is taxable. This is why it is essential to be aware of the potential impact of the CGS and always carefully consider the VAT status of any land and buildings, particularly if there is a potential sale/lease or change of use in the pipeline.