March 27th 2019

Option to tax planning

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Cowgills

Close up woman hand pressing calculator and doing finance at home office with writing make note report on notebook.

What you need to know – VAT and property – ‘Option to tax’

The option to tax allows a business to charge VAT on the sale or rental of commercial property, or in other words, to make a taxable supply from what otherwise would be a VAT exempt supply.

An important feature of the option to tax regulations is that they apply to a property for a 20-year period once an election has been made by a business. However, once that 20-year period has expired, income from either renting or selling the property can again be exempt from VAT rather than standard-rated if the business revokes its option with HMRC.

The option to tax regulations were actually introduced in 1989 so each day more options to tax are eligible for revocation.

The paperwork to revoke an option is relatively simple but the ramifications of failing to do so or making the wrong decision can be huge.

Carolyn Van Hecke, Senior VAT Manager at Cowgills specialist Property and Construction division explains in what circumstances ‘opting to tax’ might be appropriate and why it is imperative to get it right at the outset.

Option to tax – the basics

If you have an interest in commercial property, which you use for your own business purposes and don’t rent it to others, it is unlikely that you will need to opt to tax the property.

However, if you wish to generate additional income from the land and/or property by renting it out to others, subletting part of it or indeed disposing of it altogether, you should consider whether or not an option to tax should be made.

There are pros and cons of opting to tax and in view of the large sums often involved in the purchase and sale of commercial property, it is essential to take specialist VAT advice.

The option to tax is a useful tool which allows input tax recovery that would not be possible without the option to tax being made. Essentially, it creates the ability to recover VAT on related costs by turning an exempt supply – on which you can’t recover any VAT – into a taxable supply on which you can recover associated VAT.

An option to tax has no effect for some types of land and buildings.  The option can still be exercised on these, but it has no effect, and sales and lettings remain exempt or, in some cases, zero-rated.  These include buildings or parts of buildings used as dwellings, used solely for residential or charitable purposes or for individuals to build their own dwellings.

Opting to tax – a simple example

A simple example of where it might be appropriate to opt to tax is as follows:

Mr Jones purchases a commercial property for £500,000 with the intention of renting it out and is automatically charged standard rate VAT on the purchase price – £100,000.

The reason Mr Jones is charged VAT is either because the property is a commercial building that is less than three years old (classed as ‘new’ in the legislation) or the seller had an option to tax in place.

If Mr Jones rented out the property without doing anything he would not be able to reclaim this VAT because the rental income is exempt from VAT.

In fact, Mr Jones choses to opt to tax the property and rents out the property to Smith Ltd for £25,000 plus VAT. Smith Ltd is not concerned about the VAT charge – it gets full input tax recovery on its costs, but the option to tax election means that Mr Jones can now claim input tax on the cost of the building, including on any professional fees associated with the purchase and any future expenses he incurs.

If at a later date Mr Jones decides to sell the property he will have to charge VAT on the disposal, although the transaction may be eligible for treatment as outside the scope of VAT as the sale of a property letting business.

Opting to tax is a commercial decision

There are many factors to be taken into account when deciding whether to exercise the option to tax though, including:

  1. was VAT actually incurred in the purchase price
  2. is the property subject to the Capital Goods Scheme – if so, not opting to tax the property could render you liable to repay HMRC some or all of the VAT recovered on property costs through Capital Goods Scheme adjustments.
  3. is the lease you intend to grant tenant repairing?
  4. is the tenant or future purchaser likely to be in a position to recover any or all VAT charged on any rental or sale?

Once made, an option to tax can only be revoked in limited circumstances otherwise, it remains in place for 20 years.  If the property has previously been leased out as exempt, then permission to opt may be required from HMRC.

Revoking an option to tax

As Options to Tax have now come of age – i.e. where they have been in place for more than 20 years, it is now possible to revoke one which was made more than 20 years ago.

Certain conditions must be met though, and advice should be taken in respect of future exempt supplies and how that might impact on input VAT recovery.

HMRC’s permission is needed to revoke the option rather than it being an automatic right for a taxpayer when the 20-year period has expired and they will need to be convinced that there has been no tax loss caused by anti-avoidance.

However, it is not always necessary to wait 20 years. Carolyn has successfully completed option to tax revocations within the 6 month cooling off period and also under the 20 year limit.

In the case of a property purchase the revocation of the option to tax by the seller can result in VAT and SDLT savings for the buyer.  The sale of an unopted property can be much more attractive if no VAT has to be added to the selling price.

VAT and property is an extremely complex subject, and with significant sums of tax involved, it’s imperative to get expert specialist advice.