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Option to tax: What you need to know

The option to tax (‘OTT’) allows a business to charge VAT on the sale or rental of non-residential property, or in other words, to make a taxable supply from what otherwise would be a VAT exempt supply, allowing additional VAT recovery on costs than would be the case.

An important feature of the OTT 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 OTT regulations were introduced in 1989 so each day more OTT 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.

Our VAT team explain in what circumstances OTT might be appropriate and why it is imperative to understand the implications of opting to tax, and the importance of getting it right at the outset.


Option to tax – the basics

If you have an interest in non-residential property, which you use for your own business purposes and do not 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 an OTT 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 OTT is a useful tool which allows input tax recovery that would not be possible without the OTT being made. Essentially, it creates the ability to recover VAT on related costs by turning an exempt supply, on which you cannot recover any VAT, into a taxable supply, on which you can recover associated VAT (subject to the normal rules).

An OTT has no effect over 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 land, buildings or parts of buildings used as dwellings, used solely for relevant residential or charitable purposes, or for individuals to build their own dwellings.

If the property has previously been leased out as exempt, then permission to opt may be required from HMRC.


Option to tax – a simple example

A simple example of where it might be appropriate to OTT 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’ for VAT purposes) or the seller had an OTT in place.

If Mr Jones rented out the property, short term, without doing anything he would not be able to reclaim this VAT because the fall back position is that the rental income is exempt from VAT.

If Mr Jones choses to OTT the property he would rent 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 OTT 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, fit out, and any future expenses he incurs (subject to normal VAT rules).

If at a later date Mr Jones decides to sell the property he will have to charge VAT on the disposal (unless it qualifies as a transfer of a going concern for VAT purposes).

NB  There can be implications if he decides to sell to a business that can’t recover all of its VAT, so Mr Jones may consider whether it is commercially viable to revoke his option (see below).


Option to tax is a commercial decision

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

  1. Do you need to opt? Is the building going to be used for carrying on your trade? In most cases, an OTT is unnecessary.
  2. Was VAT actually incurred in the purchase price, or refurbishment costs?
  3. 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.
  4. Is the lease you intend to grant tenant repairing?
  5. Is the tenant or future purchaser likely to be in a position to recover any or all VAT charged on any rental or sale?
  6. There are complicated rules which stop a building being opted, in certain circumstances where the tenant, or party financing the purchase cannot recover all of its VAT.

Once made, an OTT 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

When an OTT has been in place for more than 20 years, it is possible to revoke it. So the grant of the interest in the land becomes exempt again.  Certain conditions must be met, 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 satisfied that there has been no tax loss caused by anti-avoidance.

However, it is not always necessary to wait 20 years. Our team have successfully completed OTT revocations within the 6-month cooling off period and under the 20-year limit.

In the case of a property purchase, the revocation of the OTT by the seller can result in VAT and SDLT savings for the buyer. The sale of an un-opted property can be much more attractive if no VAT must be added to the selling price (SDLT is calculated on the VAT inclusive price).


HMRC ‘trial’ change to acknowledgement process

Although acknowledgement from HMRC is not a legal requirement for an OTT to take effect, it provides comfort for both businesses and solicitors or lawyers on the VAT position when dealing with property transactions.

HMRC have announced that they will begin a ‘trial’ on acknowledging OTT notifications. Previously, HMRC would acknowledge the notification once an “extensive series of checks had been carried out”. During this ‘trial’, HMRC will continue to acknowledge receipt of your notification, however, this will no longer confirm its validity – this is the responsibility of the opter themselves. The OTT acknowledgement will just confirm the receipt of the OTT, no more detailed checks are carried out, and therefore no confirmation will be issued to the taxpayer that it is valid.

The aim of the ‘trial’ is to speed up HMRC’s acknowledgement process. They believe this will increase their team’s efficiency whilst maintaining legislative and security obligations and reducing the extent of delays.

However, we now understand that this is no longer a ‘trial’, and that this practice will continue, and HMRC will therefore no longer validate an OTT and will only acknowledge receipt of the OTT.

HMRC acknowledge that there is a backlog of OTT notifications and informed us that the most recent OTT will be processed first, so it can be expected that there will be a delay in receiving an acknowledgement with earlier OTT notifications.  This is a frustrating position for businesses, some of which have been waiting nearly twelve months for acknowledgements.

Under the new process, the acknowledgement letter will only include the date of the notification and HMRC do not intend to include the effective date of the option. This is not helpful in cases whereby the timing of the option is critical for example, a transfer of a going concern – if we were looking back in 10 years’ time, it may be difficult to establish what date the OTT was effective from. Therefore, it is essential that the VAT1614A and any supporting documentation is kept on your records that evidence the effective date.

These changes stress the importance of the careful preparation of the OTT notification. For example, if the notification is not signed by an authorised person, for instance it is not a director or not a director shown on Companies House, the OTT would not be valid. In addition (as mentioned above), some properties cannot be opted therefore, you need to be comfortable that your notification is accurate, that the option is effective, and you are correct to charge VAT once you have exercised the OTT. If the OTT is invalid, HMRC could unwind the position, and require repayment of input tax previously recovered which could have detrimental impacts on your business.

VAT on property is an extremely complex subject, and with significant sums of tax involved, it is imperative to get the VAT treatment right – and to get expert specialist advice where the matter is not clear cut. Our VAT team can help you understand the VAT implications of a decision to opt, both in the short and longer term.  This will help you to mitigate risk, and can create VAT savings, both cash flow and absolute.


Get in touch

Cowgills is a leading independent firm of Chartered Accountants and Business Advisors based in the North West of England – from Greater Manchester to Liverpool. We use our sector experience to deliver tailored financial solutions and support for businesses.

If you need help with any of the above, get in touch with your Cowgills contact or visit our website.

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The information was correct at time of publishing but may now be out of date.

Posted by Cowgills
25th July, 2022
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