I was recently looking at the revised VAT Notice 742a Opting to Tax Land and Property and thought it would be useful to do a short series of articles explaining the background to the changes to the rules that were introduced last year and summarising the main changes.
This initial article explains why the rules were updated. In the second article there is a summary of the main changes and how and when the new option to tax forms issued last year should be used.
I should stress that these are not detailed, technical articles. Many of my VAT colleagues have already written extensively about the new rules in the various professional publications. This article explains the background in everyday terms so that anyone with a working knowledge of VAT, accountants, finance directors and direct tax professionals, can understand.
PART ONE
The “option to tax” rules were updated in June 2008. They are explained in VAT Notice 742a: “Opting to tax land and buildings” which is here http://tinyurl.com/c64agz on the HMRC website. Now this is one of the best VAT notices, in my opinion, that HMRC have produced. It is an essential reference tool for anybody involved with opting to tax property.
Section One: Why were the rules updated?
To understand why all of the changes were necessary, you need to know a bit of history about the option to tax and how things have developed since it was introduced.
The option to tax was one of a series in changes that were introduced in 1989 relating to commercial property. The government introduced VAT on the construction of new commercial property and the freehold sale of new commercial properties (ie up to 3 years old) became standard rated on 1 April 1989.
Prior to this, the construction of new commercial property was zero rated and sales and rental of commercial property was generally exempt. This meant that to all intents and purposes, there was no VAT on new commercial property costs or commercial property rental. VAT was only incurred when properties were subject to repair, maintenance, conversion or renovation. This meant that UK businesses were at a significant advantage compared with businesses with other EC countries, especially those businesses in the finance and insurance sectors which cannot, for the most part, recover VAT.
However, as EC legislation only allows VAT relief for domestic or social housing costs, the UK was required to introduce VAT on commercial property costs to bring us into line with other EC countries. The introduction of VAT on the construction of new commercial property and new freehold sales brought commercial property costs into line with most other business costs by making it liable to VAT.
The option to tax was introduced on 1 August 1989. By opting to tax, commercial property owners could recover the VAT on the purchase or construction costs and add VAT on the rent. Their tenants could recover the VAT if they were taxable. Exempt or partly exempt businesses, however, could not recover VAT on renting or purchasing new property, so the irrecoverable VAT became an additional cost for them.
Section Two: Abuse: Anti-avoidance provisions
During the following 10 years or so, many exempt businesses (for example banks and insurance companies) entered into arrangements to minimise the effects of the additional VAT cost.
One of the most common was that an associated company, which was separately registered for VAT, purchased the new property and opted to tax it.
The property company could recover the VAT on the initial capital cost up front. It then entered into a commercial lease with the partly exempt occupant, which paid VAT on the cost of the rent over the terms of the lease. So the group as a whole was able to spread out the irrecoverable VAT cost over the terms of the lease.
To begin with, HM Customs & Excise (“HMCE”) did not object to such arrangements. However over time, it became clear that many of these arrangements were felt by HMCE to be abusive. These included setting rental levels well below normal market rates, so that the exempt business incurred lower amounts of irrecoverable VAT.
In response, HMCE introduced a series of anti-avoidance measures during the 1990s and the 2000s in response to the “abuse”.
Because these anti-avoidance provisions were developed piecemeal over several years, the legislation became horrifically complicated. They have now been rewritten and are much more readable, but even so are difficult to understand.
Section Three: Disapplying the option to tax
The main effect of the anti-abuse provisions is to disapply the option to tax in certain circumstances when the end user is an exempt or partly exempt business.
The effect of this is that the business has to bear the full VAT cost of a new building upfront. The provisions can apply to normal commercial transactions between third parties as well as those involving connected parties.
The provisions only apply where the property falls within the “Capital Goods Scheme”, ie where the cost of the property concerned is £250,000 or more net of VAT. The Capital Goods Scheme also applies to certain works of extension or conversion so it is not only new properties that are affected by the anti-avoidance rules.
These rules were originally introduced in the 1990s and expanded in subsequent years to counter new and more innovative ways that businesses and professional advisors thought up. The situation then came to a head in 2006 when the European Court of Justice ruled in the case of the Halifax Building Society. The Society had entered into a set of arrangements which had the effect of saving VAT on new property costs. HMRC asked the Court to consider whether the transactions were abusive and the Court ruled in favour of HMRC.
Following this case and various other developments, HMRC undertook a detailed review of the option to tax rules and entered into a lengthy consultation process with businesses and professional advisors. This led to a rewrite of the legislation, as well as the introduction of certain new rules and a revision of some existing rules.
Section Four: Other issues
As well as the avoidance issues, a number of other areas of concern relating to the option to tax had been identified and needed to be reviewed.
• Dwellings, residential and charitable use buildings
One of these relates to dwellings, “relevant residential” buildings such as residential homes, nursing homes, or “relevant charitable buildings” such as local community buildings. The option to tax doesn’t apply to these properties and VAT is also not charged on the construction of these buildings.
However what happens if someone purchases an existing commercial building that has been opted but wants to convert it into dwellings? The effect of disapplying the option is that somewhere along the line, irrecoverable VAT has been added to the sales price increasing the cost of the property. There were also several practical issues to review, including the need for certification to prove the end use of the property.
• Options requiring HMRC permission
Another major development was the introduction of the requirement for businesses to seek permission to “opt to tax” if the building had previously been used to make exempt supplies. This was to ensure that businesses did not enter into certain avoidance arrangements involving prepayment of exempt rents prior to incurring large VAT bearing conversion or renovation costs.
• Global options
Then there was the issue of “global” options. The original rules enabled businesses to make a single one-off “global” option, ie to tax every single property in their portfolio. But this has caused a lot of confusion over the years, including the fact that it was never clear whether this applied only to properties which were owned at the time the option was made, or every property that the owner acquired at a later date. So this area of the law was also in need of review.
• 20 year revocations
Finally, the law allows businesses to revoke an option after 20 years. As the option to tax was first introduced in 1989, the first 20 year revocations can be made in 2009. Businesses and advisors had identified a number of practical issues about the revocation rules that were reviewed.
The new VAT Notice 742a covers these and other issues in some depth, as well as introducing the new forms. In the second part of this article, I will explain how and when the new forms should be used.