Andrew Needham looks at the effects that opting to tax a property can have on associated businesses.
If a business wants to recover the VAT on the purchase, construction or renovation of a commercial property that it rents out, it will need to opt to tax it. It will then need to charge VAT on the rent or sale of the property going forward.
This seems simple, but there are many traps and one that frequently adversely affects businesses is when they rent to an associated business that cannot recover all its VAT.
Connected party rule
In some cases, a property rental business can be part of a group of associated trading companies (connected parties) and it may let the whole or part of a property to one of its associated businesses. If the associated business can recover more than 80% of its input VAT, then there is no problem for the property company.
However, if the associated business cannot recover at least 80% of its input tax (meaning it’s partly exempt), there could be problems for the property company.
Anti-avoidance rules
Following the introduction of the option to tax, some businesses tried to benefit in a way that HMRC considered to be unacceptable tax avoidance, so they introduced anti-avoidance rules.
If a property business rents commercial property to an associated business that:
- cannot recover at least 80% of its input tax;
- is covered by the capital goods scheme (CGS), which means it cost more than £250,000 to buy, construct or renovate; and
-
the VAT was recovered on these costs, and they have owned it for less than ten years,
the option to tax is disapplied to that ‘grant’ and it becomes exempt from VAT.
The effect is that if a business rents the property to a partly exempt associated business, it cannot recover the VAT on the costs of the property.
However, it can also catch out businesses that have been renting out the property to third-party tenants for some time.
Example: Repaying VAT originally claimed
A business rents out a three-story property covered by the CGS to third parties for a period of three years. In the fourth year, one of the tenants moves out, leaving one floor unoccupied. The group of companies contains an insurance broker whose lease is coming to an end, so they move into the vacant floor. The property company does not realise the consequences of this and continues to charge VAT on the rents.
However, the anti-avoidance rules kick in and the option to tax is disapplied to the lease to the associated business. No VAT should be charged on the rent and a clawback of the VAT originally claimed is now due under the CGS.
The property cost £500,000 plus VAT of £100,000 when it was purchased. The property company claimed the VAT back. It is now renting out one-third of the property to an associated business that cannot recover its VAT and so one-third of the rental income is now exempt. Each year of the remaining ten years CGS adjustment period requires a calculation to be done to repay some of the VAT originally claimed.
Current taxable use is 66%, so the calculation is:
£100,000 / 7 (remaining number of years of the CGS) x (66% (current taxable use) - 100% (original taxable use)) = £4,714.28 input tax due to be repaid each remaining year of the CGS adjustment period.
In total, the property company will need to repay £32,999.96 of the input tax originally claimed.
Practical tip
If a business owns a property and has opted to tax, it will need to repay some of the VAT originally claimed if it comes within the CGS and it is rented to a connected party that cannot recover all of its VAT.
