When the option to tax is disapplied: TOGCs; VAT 1614 and anti-avoidance

[Marie Stein]

I often get queries from people about situations where the option to tax is “disapplied”. Anything involving the option to tax (“OTT”)is a complicated subject, but there are three main situations when it can be “disapplied” so I thought it would help to explain each briefly and where to find more information.

For the purposes of this article, the term “disapplied” means that the sale is not liable to VAT.

What is the option to tax?

But first, it’s important to understand what the OTT is and why property owners choose to make the option.

The principle behind the OTT is actually quite logical. Income from the sale or rental of most commercial property is exempt from VAT. This means that the property owner/vendor doesn’t charge VAT on the proceeds from the sale or rental, but can’t normally recover VAT on related costs. In practical terms, this means that the property owner bears the burden of VAT on the property costs.

However the law allows anyone with an interest in commercial property to opt to tax the property. This means that they charge VAT on future rental from or sale of the property income and they can recover VAT on related costs. By doing this, the VAT cost is passed to the tenant or purchaser of the property.

Although the principle is logical, making the option to tax and dealing with related issues can be quite complicated and property owners should check the rules in detail and consider taking professional advice on the subject. HMRC’s guidance is VAT Notice 742a: Opting to tax land and buildings: http://tinyurl.com/c8ck4lg. It also explains when the option to tax can be revoked.

One further factor is that stamp duty land tax, where payable, is charged on the VAT inclusive value of property sales and leases. By making an OTT, a property vendor or landlord increases the stamp duty land tax for the purchaser or tenant. If the OTT is disapplied then the purchaser only pays stamp duty land tax on the VAT exclusive amount.

What are the implications of disapplying the OTT?

There are certain situations when the option to tax is “disapplied” or disregarded. In practice, it simply means that the option to tax doesn’t work in those situations. As I’ve explained below, this means that anyone planning a transaction in commercial property needs to include VAT in their planning right from the start whether or not the parties involved are related parties..

The effect of this is that the property owner’s income from the property is exempt and they can’t recover VAT on property related costs. They may also have to repay VAT on certain property costs (including the freehold purchase, lease, certain construction work) where the net value was £250,000 or more claimed from HMRC in previous years. Such properties are covered by the “capital goods scheme”.

This basically means that the burden of the VAT is shifted back to the property owner. The new owner or tenant doesn’t pay VAT on the purchase cost or rent.

This might sound like a good thing, but in practice it’s not because the property vendor or landlord will probably increase the sales price or rent to reflect the VAT they can no longer recover. The new owner or tenant can’t recover any of the VAT paid by the previous owner or landlord, even if they make their own OTT. Therefore the cost of the property or rent will be pushed up.

Either way, if your business is partly exempt, the addition of VAT to the purchase or construction of a property or to work carried out to a property, means that your overall cost increases. Over the years property owners have developed various ways to get round this and minimize the VAT cost, which in part has prompted HMRC to introduce a whole range of anti-avoidance provisions. However there are three specific provisions that apply to very common types of property transaction, so I’ve explained when these can arise.

Remember that if the option to tax doesn’t apply, then the property owner’s income from the property will be exempt from VAT, which means that the owner can’t recover VAT on costs.

So when is the OTT disapplied or disregarded?

There are 3 main situations, as follows:

Sales for non-commercial use

When the property concerned is being acquired to use as or convert into a dwelling, residential property, certain charity use and certain other non-commercial use. In this case, the purchaser must issue a VAT 1614 to the vendor or notify in writing before the price is legally fixed. See VAT Notice 742a, section 3 for more details http://tinyurl.com/qft687f. In this case, the property sale is “not affected” by the option and is exempt.

Transfers of going concerns

The next situation is when the owner of a commercial property has made the OTT and wants to sell the property as “the sale of a business as a going concern” (“TOGC”). TOGCs are not normally regarded as “supplies” for VAT purposes, however special rules apply if the vendor has opted to tax. In this case, the sale is a supply liable to VAT at 20% unless the purchaser has made the OTT and notified both HMRC and notified the vendor that their OTT will NOT be disapplied before any “relevant event”, which is normally completion, or if earlier, the payment of any deposit (unless to a third party as an independent stakeholder). See VAT Notice 700/9: Transfer of a business as a going concern, section 2 for more details http://tinyurl.com/pgsvws6.

The TOGC rules can be complicated and there are anti-avoidance provisions for properties which fall within the capital goods scheme mentioned above. But in any situation, the TOGC provisions only apply if both the buyer and seller follow certain specific steps or the transactions meets certain specific criteria, as outlined in VAT Notice 700/9.

When the option to tax anti-avoidance rules apply

This applies when:

• the person is or will become, a capital item – meaning that the value of construction of the property or certain construction services to the property – that is liable to VAT costs £250,000 OR MORE net of VAT; and
• the person granting the interest in the property expects or intends that the occupier will be using the property for either VAT exempt or almost wholly exempt business purposes.

This is only a very brief summary of the OTT anti-avoidance rules. See VAT Notice 742a, section 13 for HMRC’s full guidance: http://tinyurl.com/k7cwlph.

For the purposes of this short article, my explanations of the three conditions only contain the main principles involved. If you need to know more about any of the rules, then you must check out HMRC’s detailed guidance and the legislation. There are several definitions and more detailed provisions to consider in addition to those listed above.

What does it all mean?

There are 2 very practical reasons that the “disapplication” of the OTT affect property transactions:

The first is that the anti-avoidance rules apply not only to transactions involving connected parties, but also non-connected parties.

The second is that every time you grant any sort of interest in a commercial property, you need to know how the grantee intends to use the property AND whether or not they are partly exempt..

That’s why it’s essential to incorporate VAT into property planning right from the start.

Other anti-avoidance rules

And these are only the most common situations when the option to tax doesn’t apply. There are several other anti-avoidance provisions that HMRC can rely upon to prevent property owners or occupiers manipulating the option to tax to reduce their VAT costs. You can find a lot more information about these in VAT Notice 700/8: Disclosure of VAT avoidance schemes: http://tinyurl.com/n52uczc.

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