Big rise in VAT on property

THE VAT law on commercial property transactions underwent major changes on March 26th last; Prior to that date, with certain VAT planning schemes, it was possible to reduce or even eliminate the VAT cost of property leases for VAT exempt businesses. The Revenue Commissioners applied for and obtained the permission of the European Commission to change Irish VAT law to counter these schemes. The changes, enacted in the Finance Act 1997, effective from March 26th, are extremely complex and far reaching. The new provisions affect not only VAT planning schemes but will impact on many normal commercial transactions. Indeed I would hazard a guess that many transactions within the new regime have been inadvertently completed without consideration of the new VAT implications.

The property affected by the new rules is that developed on or after November 1st 1972 where the tenant was entitled to total or partial input credit for the VAT which arose when the property was leased and where the term of the original lease has not expired. Though the new rules apply to transactions by tenants and landlords on or after March 26th, they can also be seen as retrospective, insofar as they apply to property developed and leased before that date.

The effects of the new rules will be:

(a) A huge increase in the VAT liability arising on the assignment or surrender of leasehold interests;

(b) New leases or sales of repossessed property are now within the VAT net;

(c) Valuation for VAT purposes on an interest in property is based on the open market rent "free of restrictive conditions".

As well as any key money passing on an assignment, the VAT value of the unexpired tend of the lease must be taken into account to calculate the VAT liability on an assignment.

The impact is best illustrated by an example:

TABLE 1

Pre 26 March

Assumptions:

35yr lease from 1 Jan 1995

Rent £70,000 per annum

Key Money £100,000

Assignment: 21 March 1997

VAT Calculation.

Key Money: £100,000

Plus VAT value of rent: Not Liable

VAT at 12.5%: £12,500

Post 26 March

Assumptions:

35yr lease from 1 Jan 1995

Rent £70,000 per annum

Key Money £100,000

Assignment: 21 April 1997

VAT Calculation

Key Money: £100,000

Plus VAT value of rent: £1,000,000

VAT at 12.5%: £137,500

In the event of a surrender, the VAT will be £125,000, i.e., VAT at 12.5 per cent on the VAT value of the lease. Surrender includes forfeiture, ejectment, abandonment and failure to exercise an option to extend a lease. There is VAT payable even though no money changes hands.

In another fundamental change, the VAT liability on most assignments will be that of the assignee, not the assignor. More specifically, an exempt bank, insurance company, public body etcetera, as assignee, will be liable for the VAT. This VAT will be an irrecoverable cost. However, where the assignee is, for example, a school, hospital or doctor, the assignor must pay the VAT. In the event of a surrender, the landlord will almost invariably be the liable person.

Prior to March 26th, 1997, a landlord's VAT responsibility for a property ended with the grant of a long lease.

Since March 26th, 1997, however, not alone is a landlord liable to VAT on the surrender of a property. The property comes back into the VAT net. The landlord must account for the appropriate VAT on a subsequent short lease, long lease or sale of the property. The VAT paid on the surrender may be offset against the VAT on a subsequent lease or sale.

The kernel of the new rules dealing with leases or sales of a repossessed property is to charge VAT on the unexpired period of the old lease. The rules to achieve this are a jungle of complexity and lead to VAT treatments which are completely at odds with the commercial reality of the sale or lease.

Some examples will help illustrate the complexities and enigmas:

TABLE 2

Assumptions:

Lease 1 Jan 1985 to 31 Dec 2005, 21 years

Surrendered: 31 Dec 1997, 13 years

Unexpired Term: 8 years

New "Long" Lease

1 Jan 1998 to 31 Dec 2018, 21 years

One would think that the new lease is a long lease for VAT purposes. However this is not so; the new lease is a short one of eight years (the unexpired portion of the old lease). exempt from VAT. The landlord cannot obtain input credit for the VAT paid on the surrender. However the landlord can opt to account for VAT on a valuation of the eight years remaining of the original lease, and thus recover VAT borne on the surrender.

If, instead of a long lease in the above example, the landlord sold vacant premises, the sale price would be ignored for VAT. The sale would still be treated as an exempt short lease unless the landlord opted to pay VAT on the value of the unexpired eight years of the original lease.

TABLE 3

Assumptions:

Lease 1 Jan 1993 to 31 Dec 2022, 30 years

Surrendered: 31 Dec 1997, 5 years

Unexpired Term: 25 years

New "Long" Lease

1 Jan 1998 to 31 Dec 2012, 21 years

In this case, the landlord is liable to VAT not only on the lease of 15 years granted but must also self-account for VAT on the difference between the value of the 15-year lease created and the 25 year unexpired period of the original lease. The landlord has created a potentially significant VAT liability payable by itself. This liability did not arise under the original lease which exceeded 20 years. Landlords beware!

The Finance Act 1997 also changes the basis for valuing an interest in property. Prior to March 26th, the rent reserved in the lease was capitalised in accordance with a choice of formula in VAT Regulations.

From March 26th, the "vatable" value will be based on the unencumbered rent", which is the "rent . . . on the open market . . . free of restrictive conditions".

The new law appears to require a valuer to ignore tenants' rights, special obligations in a lease and other commercial terms which parties, at arms length, may wish to include in a lease and therefore in a rent.

This new valuation basis will almost certainly lead to significant increased VAT liabilities, not to mention disputes between taxpayer and Revenue and valuers and the Valuation Office.

This brief article has highlighted just a few of the complexities and anomalies of the new legislation. Its implementation should be postponed until the promised Statement of Practice is issued by the Revenue Commissioners.