Property VAT and option to tax can be a challenging area.
VAT reform is never out of the news and many areas are highlighted as needing simplification. The current complexities and solutions to the most common challenges faced by businesses and advisers on property VAT are described below.
What is option to tax?
Most property transactions are exempt from VAT. VAT is not charged on sales and lettings of property and no input VAT incurred on associated purchases, such as building work, fees and other expenditure, can be recovered.
Option to tax allows the conversion of this normally exempt transaction in the sale or letting of land and buildings, into standard rated, where a seller or landlord charges VAT on the sale or rental, and VAT incurred on costs can be recovered. There are, however, many detailed rules and exceptions.
If a business exercises option to tax over a property, the option applies to all its future dealings in it (unless there is a specific reason for it not to do so), until the option lapses or is revoked.
Option to tax applies per property, but does not transfer with it. A new owner needs to opt to tax in order to get the tax benefits, rather than inherit the option to tax from the vendor.
Option to tax can be overridden or disapplied:
if previously opted property is sold as part of a TOGC – VAT is not charged as the transaction is outside of scope and option to tax is overridden if the buyer opts to tax
usually where the building is designed or intended for use as a dwelling or dwellings. This can include cases where a buyer or tenant intends to convert it for residential use
if the transaction is caught by anti-avoidance rules
in some instances where the building is intended for other residential or charity uses, and the buyer or tenant certifies that intention
in some cases where the buyer or tenant is a housing association, if the housing association certifies its intended use of the property
if the buyer or tenant is an individual who intends to build their own dwelling on the site - there is no certification requirement here
in some cases involving caravan pitches or moorings for houseboats. Again, there is no certification requirement.
if the option has lapsed or been revoked. Revocation generally needs a positive action by the owner, but this does not strictly apply if it was never notified to HMRC.
How to exercise option to tax
A property can be opted at any time during ownership, and not necessarily at the point of purchase.
It is assumed a decision to opt a property is taken by the authorised beneficial owner. Within 30 days of the decision, a notification form 1614A should be sent to HMRC. It is also possible to notify HMRC by letter, provided that it contains the same information as the form, although letter notifications may take longer to process.
The proof that the form was sent and its acknowledgment by HMRC is generally sufficient evidence of a decision to opt a property.
Additional evidence such as board minutes or emails may also be requested, particularly in case of failed or late notifications which HMRC may accept (but not retrospective decisions). In this case the fact that VAT has been charged and recovered would usually be expected.
If the business is not yet VAT registered, VAT registration should be made at the same time as opting, and both forms should be sent to the registration unit together.
Practical points in completing form VAT1614A
When completing 1614A, it may be possible to ignore land registry title numbers and not have the form rejected by HMRC. It is important to include the correct address and including maps and plans showing the opted property is encouraged.
The main problems with processing forms are incorrect opter's details (eg director's details given instead of company's details) and the form being signed by someone who is not an authorised person.
Permission to opt
It is necessary to obtain HMRC’s permission to opt to tax if you have made or intend to make exempt supplies of the land or buildings within the period of 10 years prior to the date your option to tax will have effect. Some permissions are automatically given and some have to be requested using form 1614H, see 5.2 in HMRC’s VAT Notice 742A, for where automatic permission is given.
Who should exercise option to tax
The option to tax needs to be made by the person making the supplies, and in particular:
Option to tax should be exercised by the beneficial owner, not the legal owner. If there is more than one beneficial owner, they will be expected to opt together and to register for VAT as though they are a partnership.
For trusts option to tax can be made by trustees, or the trust itself. For unit trusts and pension funds, HMRC will normally expect it to be the fund manager who opts.
For most partnerships, including LLPs, the partnership should opt, and not individual partners. This applies even if only selected partners hold the property on behalf of the partnership as a whole: it is still the wider partnership that opts.
In joint ventures that do not involve partnership or co-ownership, the joint-venturers should opt separately.
To opt or not to opt - risks and traps
Opting is a long term commitment and may restrict how and when the seller can best realise property value. Purchasers may also find themselves facing a higher stamp duty bill due to the VAT uplift on purchase price.
Conversely, delaying option to tax due to uncertainties around the VAT status of a buyer or tenant may affect the seller through the lost benefit of recovered VAT as well as involve a significant cash-flow cost. This is particularly relevant if seller or landlord is not currently registered for VAT, or is incurring ongoing costs on a vacant property.
While purchasers may seek to counter the cash flow impact by submitting a VAT return early, and sellers may help by agreeing to delay the date of completion or the issue of the invoice within the 14-day rule, the cash flow cost of option to tax may have a significant impact on both the buyer and the seller, where due to the amounts involved transactions may fall through unless bridging finance is secured.
Option to tax locks other associated fees, such as service charges, into the same VAT treatment as the underlying supply. Whether this is tax neutral or detrimental to the tenant will depend on how much of the VAT can be recovered.
Further complications for landlords arise when renting to both exempt and non-exempt tenants. For example, commercial property with residential units rented to a retailer, and offices rented to an exempt insurance company. In order to recover VAT on the refurbishment of the retail space, the landlord would have to opt to tax, but this would increase the rent charged to the exempt insurer, as option to tax would apply to the whole commercial property. Usually splitting the title between retail and office parts and transferring the retail space to a separate company which then exercises option to tax may be the only way to remedy the situation, subject to appropriate disclosures being made to HMRC, if applicable.
Restriction of VAT recoverability due to mixed use
Occupation of a property by its owner who carries out standard taxable supplies, as well as sublets space to a tenant under option to tax, may sometimes result in more VAT restriction than anticipated. If, for example, you occupy half the building in activities that are 20% taxable, and use the other half in 100% taxable lettings, you might expect to recover (100% + 20%) ÷ 2 = 60% of the VAT on costs related to the building as a whole. HMRC will not necessarily agree to this, and there is a danger that you will still only recover 20% of the VAT (the Tribunal decision in Farnham Physiotherapy and Sports Clinic v Revenue & Customs  UKVAT V20004)
Restriction of VAT recoverability incurred before option to tax is exercised
VAT incurred prior to exercising the option to tax cannot be recovered, unless it related to costs incurred strictly in connection with the supply of the opted property (its sale or letting).
For example, if a VAT registered trader decides to sell a property and incurs refurbishment costs with a view to sell and then decides to opt to tax the property as he finds a buyer who can recover VAT on the purchase, VAT suffered on the refurbishment will be recoverable.
In practice, vendors may find themselves in a position where it is not known until much later after such costs were incurred whether option to tax and VAT registration is relevant and beneficial. This could apply in case of developers facing uncertainties in relation to planning permission application outcomes or availability of finance to continue the build. Thanks to concluded past VAT cases, in these situations pre-option VAT may be either partly recoverable and treated as residual VAT subject to partial exemption method, or fully recoverable if there is demonstrable, evidenced and strong intention to use the property in a taxable supply (Beaverbank Properties Ltd (VTD 18099)), even if subsequently no such taxable supply is realised, as the project is aborted.
However, where permission from HMRC is needed to opt to tax, no recovery of input tax should take place until option to tax is actually granted.
Once option to tax is exercised past VAT may be recovered and several avenues can be used to achieve this:
Through your partial exemption annual adjustment, if the input tax was incurred during the same partial exemption year. Provided that the taxpayer was required to carry out an annual adjustment in the previous year, the taxpayer may (but need not) use the previous year's adjusted annual recovery percentage as the provisional recovery percentage for the current year (avoiding the need to calculate the rate for each return made in the tax year).
Under regulation 109 of the VAT Regulations. This does not apply if you have used the expenditure in the meantime, even if only to a limited extent.
Under the CGS. This will only allow you to recover some of the VAT but it can apply where you have already made use of the expenditure. If, for example, you refurbished the property five years ago, opting now might allow you to claim back half the VAT through the CGS. The CGS only applies where VAT was incurred on expenditure of £250,000 or more.
If the CGS does not apply, and you were not registered when you incurred the expenditure, under the rules for pre-registration VAT, subject to the following limitations:
No VAT can be recovered if it was incurred more than four years before registration.
VAT on services can only be claimed if it was incurred within six months before registration. This may include, among other costs, professional fees and rent under a lease for a term of 21 years or less (in Scotland, of less than 20 years), since this is a supply of services. Case law also indicates that the six-month rule generally applies to both the goods and services elements of building work.
HMRC also consider that VAT cannot be recovered on building work, even within the six-month period, if the property was acquired more than four years before registration, although in practice they might still be prepared to make a repayment in these cases.
Matt is a teacher providing maths tuition which is VAT exempt. He has had a lease on premises he teaches from, for many years. In addition to teaching Matt sells teaching aids and stationery to small local businesses and is VAT registered. As he provides both taxable and exempt supplies, he can only recover 5% of the VAT he incurs.
Matt wishes to retire and has been looking to sell the lease. He does not exercise option to tax to start with because he does not know who will take the property.
In the few years before he retired, he had incurred input tax on:
After Matt retires and moves out, he incurs VAT on the following costs:
redecoration with a view to sale
fees in connection with the sale
abortive negotiations to surrender the lease
Eventually, Matt finds a buyer and assigns the lease to a small firm of solicitors. They are fully taxable, so he opts to tax at the time of the sale.
Matt can recover VAT on:
surveyor's fees – if these were incurred purely with a view to dispose of the lease and are a cost of disposal
rent – 5% per partial exemption as this related to his business at the time
refurbishment – initially 5% per partial exemption if this refurbishment was linked to his teaching business at the time; further recoverability may depend on whether refurbishment qualifies as CGS.
redecoration with a view to sale – option to tax makes the sale of the property a taxable supply, so VAT can be recovered as redecoration relates to the taxable sale
fees in connection with the sale - option to tax makes the sale of the property a taxable supply, so VAT can be recovered as fees relate to the taxable sale
What Matt cannot recover VAT on:
rent since his retirement
abortive negotiations to surrender the lease.
More VAT could be recovered under the CGS if the project cost at least £250,000. If Matt incurred VAT of £30k five years ago, he will have recovered £1.5k of this at the time. On the sale, the CGS might allow him to recover another £13.5k (£30k x 5÷10) - £1.5k = £13.5k), subject to HMRC's agreement that the costs incurred qualify for CGS and their value is still reflected in the building.
If the refurbishment cost less than £250,000, CGS does not apply and there is no basis for Matt to recover further VAT.