VAT Option to Tax
It has been with us for nineteen years…..but still causes confusion!
The option to tax was introduced in 1989. It represented a major change in the world of VAT, in that it effectively gives a taxpayer the “option” to decide whether certain supplies involving land are going to be standard rated or exempt. This is quite a revolutionary concept……making your own decision about charging or not charging VAT!
The basic principles of the option to tax rules are as follows:
- many supplies involving land (e.g. rental income charged by a landlord to a tenant) are exempt from VAT under VAT Act 1994, Schedule 9, Group 1 (Land). The positive point about this situation is that no output tax needs to be charged on income received from relevant supplies; the disadvantage is that no input tax can be reclaimed on any related expenditure
- the loss of input tax may be significant for a business – and the non-charge of output tax may not be a problem if the customer (tenant) could reclaim VAT on his own return
- by making an election to “opt to tax” either land or a building (or part of a building) all supplies connected with the land in question become standard rated and input tax can now be reclaimed.
- the option to tax decision must be notified in writing to HMRC and, once an election has been made, it cannot be revoked for 20 years (after an initial cooling off period that applies in limited situations)
- the option to tax election can only be made in relation to land/buildings used for a non-residential purpose. This is good news for tenants in flats – your landlord will never charge you VAT!
To give an example of when the option to tax election should almost certainly be made, consider the following situation:
John is not VAT registered and has bought an office building for £500,000 plus VAT. He plans to spend £300,000 plus VAT on renovating the building and then rent it out for £40,000 per year to a large firm of accountants on a long lease. What are the VAT issues here?
John has the option of doing nothing as far as VAT is concerned……but this would be very unwise! If he decided to do nothing, the rental income charged to the accountants would be exempt from VAT. This means he would not need to worry about registering for VAT because he is not making taxable supplies. However, the major problem is that he would not be able to reclaim £140,000 of input tax on the cost of the building and repair works (£500,000 + £300,000 x 17.5% = £140,000).
John should apply to become VAT registered, and at the time of his application, make an election to opt to tax the building he has bought. He will then charge output tax to the accountants renting the building from him – but they will not be concerned about this because accountants can reclaim input tax. The real “win”, however, is that £140,000 input tax can be claimed by John – he can also claim input tax on any other costs connected to this building.
Note of caution
In example 1, I highlighted the very significant benefits to John of making the option to tax election on his office building and making all supplies taxable. However, it is important to be aware of a couple of other issues.
As mentioned earlier, the option to tax election means that all supplies in connection with the building become taxable rather than exempt – and this means the eventual sale of the property as well. Again, this will not be a problem in many situations, either because the business buying the building could reclaim input tax or possibly make an option to tax election as well.
However, there are some types of business that are unable to reclaim input tax because they are making exempt supplies – and the VAT charge would almost certainly end their interest in buying the property. Businesses in this category would include:
- insurance companies
- banks and building societies
- trade unions
- private schools
- betting shops
The other point to emphasise to John is that although the output tax charge to the accountants is not a problem, it could be for other tenants (e.g. at the end of the lease with the accountants). It is likely that potential tenants in the five categories of business above would be deterred from renting the building by the VAT charge – it is effectively adding 17.5% to their rental cost.
In summary, the key approach suggested is that although it can appear that the option to tax election is a “win:win” outcome, the potential limitations still need to be considered. To quote the old saying….nothing is ever perfect! Always remember, the option to tax election is a twenty-year decision…..and a lot can happen in twenty years!
Don’t forget the subletting arrangement
The first point to be aware of is that there is no such thing as “an opted building”. Each VAT registration must make its own decision as to whether it opts to tax its interest in the building in question – and this applies to sub-letting arrangements as well. See example 2.
The accountants from example 1 have decided to sublet 25% of the building to a firm of solicitors. The firm’s VAT advisers say that because the landlord (John) has opted to tax his interest in the building, the accountants must also opt to tax their interest – and charge VAT to the solicitors on any rental income that is received.
Solution – this is not correct. Although the accountants have the legal right to opt to tax their interest in the building, this must be based on their own decision according to the commercial benefits in terms of input tax savings etc. They do not have to opt to tax the building just because John has made an earlier election.
No time limit as far as “interest” in land is concerned
I had an interesting query a couple of years ago from an accountant whose client was organising a one-day antique fair. Could the client opt to tax her interest in the land that was being used for the fair, even though it was just a one-day event? The answer was “yes” – and this gave significant input tax benefits to the client. She opted to tax the land and charged output tax to the antique dealers on their pitch rental fees – not a problem because they were virtually all registered for VAT.
I forgot to tell HMRC about my election……..
This is the most common problem of all.
The important point to remember is that the option to tax is a bit like the Lord of the Rings film – it comes in three parts:
- making the decision that a land/building will be subject to the option to tax
- notifying this decision to HMRC in writing – within 30 days of the decision being made
- charging VAT on rental income etc from the date that the election becomes effective – and enjoying the input tax benefits as well
Many taxpayers forget stage two of the above process – but the good news is that it is not a problem as long as stages one and three have been properly executed. In principle, HMRC accept a belated notification as long as long as it is not an attempt by a taxpayer to “backdate an option” in order to gain a VAT advantage.
For further information on this issue, see HMRC Business Brief 13/05
No option to tax can be made on residential properties
It should be remembered that the option to tax is only available to non-residential properties. It would not be available for example in the case of a building let out as flats for residential accommodation.
Opting to tax part of a building
Taking the above issue a stage further, what would happen if a business bought a property that consisted of a ground floor shop (non-residential) and first floor flat (residential)?
The answer to this question is that the option to tax regulations allow a taxpayer to make an option to tax election in relation to “part” of a building – so there is no problem in making an election just for the ground floor shop.
Sale of a business
The sale of a business as a going concern is outside the scope of VAT as long as certain important conditions are met (e.g. new owner carries on the same type of business, no significant break in trading etc).
A common issue that arises is where the sale includes a property (along with other assets such as stock, fixtures and fittings and goodwill) and the seller has made an option to tax election on this property. The procedure is as follows:
- the buyer of the business must also opt to tax his interest in the land or buildings – and must have given notice of this election before the date of the sale
- as an anti-avoidance measure effective since March 2004, the buyer must also notify to the seller in writing that his option to tax the land or building in question will not be disapplied
- if the above two stages are carried out, the proceeds of the property part of the business sale will also be outside the scope of VAT – of not, the property element is standard rated
As mentioned at the beginning of this article, the option to tax rules were introduced in 1989 – and once an election has been made, it cannot be revoked for twenty years.
2009 is therefore a milestone year – because it means some taxpayers will be able to revoke options made back in 1989. If an option to tax is revoked, then supplies involving the land or building will again become exempt – this may provide benefits in many situations.
The finer details of the revocation process are still to be confirmed.