Purchasing commercial property is rarely straightforward from a VAT perspective, and whether you’re buying premises to trade from or as an investment, it is crucial to understand the VAT implications as soon as possible to avoid an unexpected tax liability.

This article sets out some of the key areas in VAT that you should be aware of before purchasing a commercial property.

Is Commercial Property Subject to VAT?

The starting point is that the sale or lease of commercial property is ordinarily exempt from VAT. At first glance, this might sound like good news – but VAT exemption isn’t always as beneficial as it seems. If you’re selling a property as a VAT-registered business, being unable to recover the VAT on your costs and professional fees could be a real disadvantage. (From a Buyer’s perspective, if this happens, then the seller is likely to increase the overall price for the transaction.)  This is where the Option to Tax becomes important.

Regardless of the Option to Tax, there is a special provision such that the freehold sale of a new (less than three years old) commercial property is ordinarily subject to VAT at 20%.

What is the Option to Tax?

The Option to Tax (OTT) allows a business or individual to voluntarily “elect” to charge VAT on the sale or rental of commercial property that would otherwise be exempt. Once made, the option applies to a specific property (or plot of land and any buildings built thereon) and, in most cases, cannot be revoked for 20 years.

When a seller or landlord has opted to tax a property, VAT at the standard rate (currently 20%) will be charged on the sale price or rent. For buyers and tenants who are themselves VAT-registered and using the property for taxable business purposes, this is often not a problem – they can simply reclaim the VAT through their VAT return. However, for buyers who are exempt from VAT, partially exempt, or not VAT-registered at all – such as insurance companies – an opted property can represent a material additional cost that cannot be recovered.

Importantly, businesses should note that:

• It is not possible to opt to tax one part, or floor, of a building; instead the OTT will apply to the building as a whole;
• The ‘building’ is not opted, instead it is the supplier’s interest in the building that is opted, i.e. if a landlord opts to tax the building to a tenant, and the tenant sublets that building, then potentially each of the landlord and the tenant will separately have to opt to tax their own interest in the building; and
• You can opt to tax a building that you don’t own, i.e. it is possible to opt to tax a building which you are in the process of buying, before you actually own it.

Buying as Your Trading Premises

If you’re purchasing commercial property to trade from, the key question is whether the seller has opted to tax. If they have, VAT will be added to the purchase price – potentially adding 20% to what is already likely to be a substantial transaction. If your business is fully VAT-registered and uses the property exclusively for taxable activities, you should be able to recover that VAT in full. However, if your business is partially exempt – meaning it carries out a mix of VATable and exempt activities – your VAT recovery may be restricted, and specialist advice should be sought before proceeding.

You should also be careful if you intend to sublet any part of the building to group companies and/or third parties.

Buying as an Investment

For property investors, the option to tax decision is particularly significant. If you are acquiring a tenanted commercial property with a view to receiving rental income, you will want to consider whether to opt to tax the property from the outset. Doing so will allow you to recover VAT on acquisition costs and any ongoing expenditure, but it will also mean charging VAT on your rents – which may or may not suit your tenants depending on their own VAT position.

Where a property is being purchased as a going concern – for example, an existing investment property with tenants already in place – it may be possible to structure the transaction as a Transfer of a Going Concern (TOGC), such that no VAT is charged on the purchase price. This can be highly advantageous, but the conditions for TOGC treatment are strict and must be carefully met.

Transfer of a Going Concern (TOGC)

A TOGC is one of the most valuable VAT reliefs available in commercial property transactions, yet it is also one of the most frequently misunderstood. Where the conditions are met, the sale of a property business is treated as neither a supply of goods nor a supply of services for VAT purposes – meaning no VAT is chargeable on the transaction at all. For a buyer, this removes the need to fund potentially large amounts of VAT upfront (and potentially reduces the SDLT amount payable), and for a seller, it simplifies the transaction considerably whilst still (usually) enabling them to recover VAT on their associated costs.

For TOGC treatment to apply in a property context, a number of conditions must be satisfied. There must be a ‘business’ being transferred, i.e. the property must be tenanted – or at least there must be a genuine intention to continue the letting business.  If the seller is VAT-registered, then the buyer must themselves be VAT-registered (or become VAT-registered as a result of the transfer) at the time of the transaction. Critically, if the seller has opted to tax the property, the buyer must also opt to tax the property before the sale completes and must notify HMRC accordingly. Failure to do so will mean that TOGC treatment cannot apply, and VAT will become chargeable on the full purchase price (if the property is new or has been opted for tax by the seller).

It is worth emphasising that TOGC is not optional – both parties need to carefully assess whether the conditions are met, and the consequences of getting it wrong can be significant. If a seller incorrectly treats a transaction as a TOGC and fails to charge VAT, they may find themselves liable to account for that VAT to HMRC out of their own pocket. Equally, a buyer who relies on TOGC treatment without properly satisfying the conditions could face an unexpected VAT liability after completion.

Given the sums typically involved, specialist advice at an early stage is essential.  We also recommend that you carefully review the terms of the transaction and are clear on who holds the liability to pay any VAT (or interest, penalties and third party costs) if the conditions for TOGC are not met.

Partial Exemption

Partial exemption arises where a business makes both taxable supplies (on which VAT is charged) and exempt supplies (on which no VAT is charged). In such cases, the business cannot recover all of the VAT it incurs on its costs – only the proportion that relates to its taxable activities.

In a property context, partial exemption is particularly relevant where a business owns or occupies properties that are used for a mix of taxable and exempt (e.g. residential) purposes, or where a property investor has a portfolio containing both opted and non-opted properties. For example, a business that provides VAT-exempt financial services from its premises will not be able to recover all of the VAT incurred on the acquisition or running costs of that property, even if the seller has opted to tax and charged VAT on the purchase price.

The default method for calculating how much input VAT can be recovered is based on the ratio of taxable turnover to total turnover. However, this standard method does not always produce a fair result, and HMRC will sometimes agree a “special method” that more accurately reflects the actual use of costs across taxable and exempt activities.

There is also a “de minimis” test, which allows businesses to recover all their input VAT – including that which relates to exempt supplies – provided the amount of exempt input tax is below certain thresholds. Businesses should review their position annually to determine whether they fall within the de minimis limits.

Where partial exemption is a factor, the interaction with the option to tax and the Capital Goods Scheme (see below) can become particularly complex. A business that opts to tax a property it uses partly for exempt purposes may find that its VAT recovery is still restricted, and adjustments under the Capital Goods Scheme may be required if the proportion of exempt use changes over time.

Property owners subject to the Capital Goods Scheme are required to keep detailed records of the property, the original VAT incurred and the annual intervals, throughout the adjustment period. Keeping on top of these obligations is important, as errors can attract penalties as well as unexpected VAT liabilities.

The Capital Goods Scheme

The Capital Goods Scheme (CGS) is a VAT adjustment mechanism that applies to certain high-value capital items, including commercial property, typically where the purchase, construction or refurbishment cost exceeds £250,000 plus VAT.

When a business acquires a property for use in its taxable trade and recovers input VAT on the purchase, the CGS requires that VAT recovery to be monitored and, if necessary, adjusted annually over a ten-year period to reflect any changes in the property’s use between taxable and exempt (or non-business) activities.

As an example, if a property is initially used fully for taxable supplies and full VAT recovery is claimed, but part way through the CGS period the owner sells the property without having opted to tax, the disposal is treated as an exempt supply of land. This represents a shift from taxable to exempt use, triggering an adjustment under the CGS. The seller would therefore be required to repay a proportion of the input VAT originally recovered, calculated by reference to the remaining intervals in the ten-year adjustment period.

For instance, if the sale occurs in year 4, the business would typically need to repay 6/10 of the VAT originally recovered, reflecting the remaining years of exempt use, which can create a significant and often unexpected VAT cost if not planned for carefully.

Clawback Arrangements

Separately to the CGS arrangements, if a business intends to use the property for making taxable supplies and recovers VAT charged to it on that basis, but then before it actually uses that property for those supplies it changes its intention and now intends to use the property for exempt purposes, then it may be necessary to repay the VAT previously recovered back to HMRC.  This is subject to a six year cap.

It is important to consider how the clawback provisions (and reciprocal payback provisions) interact with CGS if the original property cost was greater than £250,000 plus VAT.

A Few Practical Points to Bear in Mind

VAT on commercial property can interact in complex ways with other taxes, particularly stamp duty land tax (SDLT), since SDLT is calculated on the VAT-inclusive price where VAT is chargeable. This can significantly increase the overall cost of a transaction if not planned for in advance.

The option to tax rules also contain a number of anti-avoidance provisions (e.g. for development financiers), and specific exemptions / overrides (most notably for dwellings and also rules around “relevant residential” and “relevant charitable” use) which can restrict or disapply an option to tax in certain circumstances, regardless of the owner’s intentions.

Given the sums of money involved and the long-term, largely irrevocable nature of many of the decisions discussed in this article, we strongly recommend taking specialist VAT advice before exchanging contracts on any commercial property transaction.

This article is intended for general information purposes only and does not constitute tax or legal advice. VAT legislation is complex and the rules applicable to any particular transaction will depend on the specific facts and circumstances involved. You should always seek specialist professional advice before making any decisions in relation to VAT and property.