Progressing to exchange of contracts - VAT implications in property contracts

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Overview

Value Added Tax (VAT) is a primary factor in property transactions, presenting many challenges for legal professionals and SQE1 FLK2 exam candidates. This article examines VAT's role in property contracts, highlighting important areas essential for both legal practice and exam success. We explore VAT's application in residential and commercial contexts, the option to tax, and vital contractual elements to provide readers with a solid understanding of this complex legal area.

VAT Basics in Property Transactions

Legal Framework

The Value Added Tax Act 1994 (VATA 1994) and related regulations govern VAT's role in property deals. Key sections include:

  • Section 30: Basis for zero-rating and exemptions
  • Schedule 8: Specifies zero-rated supplies
  • Schedule 9: Lists exemptions, focusing on land and buildings

Residential Property

Residential transactions usually fall under VAT exemptions as per Item 1 of Group 1, Schedule 9. However, exceptions include:

  1. New Constructions: The first sale or long lease of newly built residential properties is zero-rated if completed within three years.

  2. Conversions: Sale of converted non-residential buildings to residential use may be zero-rated under specific conditions.

  3. Renovations: Certain substantial renovations may qualify for a reduced VAT rate of 5%.

Commercial Property

Commercial transactions involve more complex VAT rules:

  1. New Properties: New commercial properties sold within three years are subject to standard VAT.

  2. Existing Properties: Typically VAT-exempt, but exemption can be waived through the option to tax.

  3. Mixed-Use Properties: VAT apportionment might be needed, following guidelines in VAT Notice 742.

The Option to Tax

This "election to waive exemption" is vital for commercial property, allowing VAT charging on otherwise exempt supplies.

Legal Points and Procedures

Outlined in Schedule 10, VATA 1994, and VAT Notice 742A, key points include:

  1. Notification to HMRC within 30 days.
  2. The option typically lasts 20 years but can be revoked under certain conditions.
  3. Dis-application may occur in cases like a transfer of a going concern.

Considerations

  1. Input VAT Recovery: Opting allows reclaiming VAT on property expenses.

  2. Buyer Impacts: Significant for buyers unable to recover VAT, such as those making exempt supplies.

  3. TOGC: Some cases may lead to dis-application, like a transfer of a going concern.

Example: Commercial Property Deal

Imagine Company A sells a five-year-old office building to Company B for £1,000,000. Company A had opted to tax:

  1. VAT Charge: Sale is subject to 20% VAT, totaling £200,000.

  2. Buyer's Situation: If fully taxable, Company B can reclaim VAT, but exempt businesses face a higher effective price.

  3. TOGC: Qualifying sales as a transfer of a going concern may be outside VAT's scope.

This illustrates the need to understand both parties' VAT status when structuring deals.

Contractual VAT Considerations

Proper contract drafting is vital to avoid disputes and clarify VAT duties.

1. Price and VAT

Contracts should clearly outline:

  • Whether prices include or exclude VAT
  • Property's VAT status
  • Conditions related to the tax option

2. VAT Payment and Recovery

Include clauses on:

  • Who pays VAT to HMRC
  • VAT payment timing
  • VAT invoice obligations

3. TOGC Terms

If TOGC is intended:

  • State conditions for TOGC treatment
  • Parties' VAT status assurances
  • Adjustments for unmet TOGC conditions

4. Indemnities

Consider safeguards against:

  • Unexpected VAT liabilities
  • Penalties from incorrect treatments

5. Option to Tax

Address explicitly:

  • Conditions for opting to tax
  • Notification timing to HMRC

Case Study: Mixed-Use Development

Developer GreenBuild Ltd sells a newly completed development to PropInvest PLC for £10 million:

  1. VAT Assessment:

    • Residential: Zero-rated
    • Commercial: Standard-rated

  2. Contract Details:

    • Price split: £7 million residential, £3 million commercial.
    • 0% VAT on residential, 20% on commercial.

  3. Buyer's Role:

    • PropInvest opts to tax commercial units to reclaim input VAT.
    • Must calculate partial exemption for VAT recovery.

  4. Contract Specifications:

    • Clear price division and tax option clauses.
    • TOGC provisions for continued lettings.

Conclusion

Understanding VAT in property contracts is important for both exam success and effective legal practice. The interplay between residential and commercial treatments, tax options, and important contract provisions demands a strong understanding of both theory and practice, preparing candidates to handle complex property transactions confidently.

Key Points Summary

  1. VAT varies significantly between residential and commercial properties.
  2. New residential properties are typically zero-rated.