Sorting out the confusion about VAT recovery rules

[Anonymous]

One of the most tedious tasks for business owners and accountants has got to be dealing with the various VAT recovery rules. And the rules are particularly relevant for you if you’re a property investor, developer or landlord. You may never have heard of some of the rules mentioned in this article, but if you want to avoid unexpected costs and not lose any of that hard-earned profit, you may have to factor these issues into your financial planning before you start spending any money.

The VAT recovery principle is quite simple: you can normally claim VAT on goods and services used to make taxable supplies, but you can’t normally claim VAT on goods and services used to make exempt supplies (“exempt input tax”).

If you make both taxable and exempt supplies, the partial exemption rules define how you calculate how much VAT you can claim, whether you will use or intend to use the goods or services to make supplies straight away OR in future years.

Many of you will be familiar with the partial exemption process and the calculations that you do for each VAT return and for the partial exemption annual adjustment. HMRC VAT Notice 706: Partial exemption contains the detailed rules.

It’s the additional rules – the capital goods scheme (“CGS”) and the clawback/payback (C/P) provisions that seem to cause confusion so I thought it would help to briefly explain their purpose and when they apply.

What does the word “USE” mean?

But first, we have to define the word “USE” in the context of VAT recovery.

Costs are attributed to either taxable or exempt supplies according to whether the goods or services are used for those supplies.

For example a housebuilder who intends to sell new houses will USE goods or services for making zero-rated taxable supplies, while a residential landlord USES goods or services for making exempt supplies of property leases.

Partial exemption

Partial exemption is when a business incurs VAT on goods and services that are used to make both taxable and exempt supplies. The partial exemption rules are explained in HMRC VAT Notice 706: http://tinyurl.com/o2jl7mv.

The rules are used to calculate how much VAT you can claim in the 12 month “VAT year” in which you incur the expenditure.

The “VAT year” runs to the end of March, April or May depending on the business’s VAT accounting periods.

This is sometimes called the “first use” or “intended use” attribution.

• “First use” means that the goods or services are actually USED to make taxable or exempt supplies in the VAT year in which they were acquired.
• “Intended use” is when the goods or services aren’t used to make supplies in the VAT year in which they were acquired, but you can claim the VAT if you INTEND to use the goods or services to make taxable supplies, while you can’t, in principle, claim VAT on goods or services that will be USED to make exempt supplies in the future.

Under the “direct attribution” rule, you directly attribute expenditure that is used to make either taxable or exempt supplies:

• You can claim VAT on goods and services used or will be used to make taxable supplies.
• You can’t normally claim VAT on goods and services used or will be used to make exempt supplies. This VAT is called “exempt input tax” and can only be claimed if it relates to certain types of passive exempt income; e.g. bank interest ; or falls within the “de minimis” limit which is currently £7,500 and 50% of all input tax.

VAT on costs that can’t be directly attributed to either class of income; such as VAT on overhead costs; is apportioned between taxable and exempt supplies.

This is usually called the partial exemption recovery rate and means the proportion of VAT on overhead costs that can be claimed. This is calculated by using either the partial exemption standard method – which is based on the proportion of taxable and exempt income in the VAT year – or a special method, to reflect the extent to which overhead costs are “USED” or “will be used” to make taxable supplies.

The main principles of VAT recovery are quite logical, but carrying out the calculations and following the detailed rules – which are explained in Notice 706 – can be very complicated.

But where do the CGS and P/C fit in?

The “capital goods scheme”: changes of ACTUAL use

This CGS applies where you use the goods/services in the year in which you incurred the cost; i.e. the “first use” principle.

The scheme applies if you use the goods/services to make a different “class” of supply in future VAT years, i.e. from making taxable supplies in the initial year to making exempt supplies in future years, from exempt to taxable, or mixed use.

However it only applies to VAT on certain specific assets or types of expenditure. The adjustments are made over a number of years following the VAT year in which you incurred the expenditure.

It applies over a period of five years for computer equipment, boats and aircraft and other vessels costing £50,000 or more and ten years for properties or certain work on properties that cost £250,000 or more. So in the case of property, any VAT paid on purchase is adjusted over a ten year period.

Example

For example, suppose your VAT year runs from 1 April – 31 March. You pay £1m plus £200,000 VAT on the purchase of a commercial property in May and start leasing the property in July; so you are using the property to make supplies in the same year.

You let the property exempt from VAT so you can’t claim any of the VAT on the purchase or any other related costs in that year.

Four years later, you decide to opt to tax the property and charges VAT on the rent. Because the property is now being USED to make taxable supplies, under the CGS you can, in principle, claim 10% of the VAT paid on the purchase in that year (year five) and the next five years of the adjustment period. This means that you should be able claim 60% of the VAT paid on the purchase cost by the end of the ten year period.

Full details are in VAT Notice 706/2: Capital goods scheme: http://tinyurl.com/pr5d3sy.

Clawback/payback: change of INTENDED use when things don’t go to plan

“Clawback” and “payback” apply when you don’t use the goods/services in the VAT year in which you incurred the cost; i.e, the “intended use”.

The provisions apply when you don’t use the goods or services to make the “class” of supply (i.e. taxable or exempt) as you originally intended when the cost was incurred; in other words when things don’t go to plan; or if you change your mind (i.e. intention) about the class of supply that will be made.

If you don’t make the supplies that you intended, or you change your intention after the end of the partial exemption year in which you purchased the goods and/or services, you have to recalculate your recoverable VAT for the partial exemption year in which you bought the goods and/or services. You do this on the basis of how the goods and services are actually used or to how you plan to use them.

Example

A very common example is a housebuilder who claims VAT on goods and services because he intends to sell new homes, which will be zero-rated. However he can’t sell the houses and ends up renting them on short term leases, which are exempt from VAT.

Therefore he has “changed from the intended use” of making taxable supplies and instead uses the goods and services to make exempt supplies. Therefore he must repay some or all of the VAT previously claimed on the costs.

See VAT Notice 706; section 13 for further information: http://tinyurl.com/nhv3rpo.

Important differences between the CGS and C/P

There are two other important differences:

• “Clawback” and “payback” apply to VAT on ANY goods and services; not just those specific types of expenditure covered by the CGS. For example, it could also apply to professional services or office equipment.
• The C/P adjustments are normally required up to six years after incurring the expenditure, while the CGS is based on 5 or 10 year adjustment periods.

What do the CGS and clawback/payback have in common?

Under normal VAT recovery rules, you calculate how much VAT you claim in the VAT year in which the costs were incurred.

If you have to make any CGS or C/P calculations, you calculate the difference between the amount of VAT claimed in the VAT year in which the expenditure was incurred. In either case, you may have to repay some of the VAT originally claimed to HMRC or you may be able to claim more VAT than was originally claimed.

As with anything to do with partial exemption, there are detailed rules for making calculations for both the CGS and C/P adjustments. However you can apply to HMRC to use a different method if you think that the result using your normal partial exemption method isn’t “fair and reasonable”.

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