Progressing to exchange of contracts - VAT implications in p...

Learning Outcomes

This article explains the VAT implications of property transactions and their impact on contract drafting and negotiation, including:

• VAT chargeability on sales and lettings of land
• Exempt versus zero‑rated supplies
• Legal and commercial effect of the option to tax on future supplies of a property
• Drafting, negotiation, and interpretation of VAT provisions
• Selection and use of the correct standard condition set (SC vs SCPC)
• Use of SCPC Part 2 condition A1
• Management of VAT risk between exchange and completion
• Apportionment of mixed‑use prices
• Impact of VAT on SDLT/LTT (duty calculated on the VAT‑inclusive amount)
• TOGC treatment and contractual protections
• VAT‑sensitive counterparties
• s.89 VATA 1994 where a landlord opts after grant
• Evidence requirements at exchange (e.g. HMRC notification of option to tax, VAT invoices) for pricing and payment certainty

SQE1 Syllabus

For SQE1, you are required to understand the VAT implications of property transactions and how they affect the drafting and negotiation of contracts, with a focus on the following syllabus points:

• The VAT status of residential and commercial property transactions
• The legal effect and procedure for exercising the option to tax
• The impact of VAT on contract price and payment obligations
• The treatment of mixed-use properties and apportionment
• The importance of clear VAT clauses in property contracts
• The relevance of VAT for the timing of exchange and completion
• How the Standard Conditions of Sale (SC) and the Standard Commercial Property Conditions (SCPC) deal with VAT
• Using SCPC Part 2 condition A1 to manage VAT risk and changes in the law
• The effect of s.89 VATA 1994 where VAT is introduced on rent after grant
• The conditions for TOGC treatment and how to guard against failure
• SDLT/LTT being calculated on VAT-inclusive consideration

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. When is VAT chargeable on the sale of a commercial property?
2. What is the effect of the option to tax in a property contract?
3. How should a contract deal with the possibility that VAT may become chargeable after exchange but before completion?
4. What is the VAT treatment of a new residential property sold by a developer?

Introduction

VAT is a key consideration in property transactions and can significantly affect the price, the parties’ obligations, and the drafting of the contract. Pricing and risk allocation turn on the correct VAT status of the supply, the option to tax, and the interplay with the chosen standard conditions. You must be able to identify whether a supply is exempt or taxable (and at what rate), understand how the option to tax converts an exempt commercial land supply into a standard‑rated supply, and incorporate clauses that deal with VAT becoming chargeable between exchange and completion. A frequent exam pitfall is confusing zero‑rating (taxable at 0%) with exemption (not taxable at all). Another is failing to recognise VAT‑sensitive businesses that cannot recover input VAT and may seek contractual protections or price adjustments. This article explains the main VAT rules for property contracts, focusing on residential and commercial property, the option to tax, and the practical implications for exchange of contracts, including SC/SCPC mechanics, TOGC, and rent VAT under s.89 VATA.

Key Term: VAT-exempt supply
A supply of goods or services that is not subject to VAT. Most sales and leases of existing residential and commercial property are VAT-exempt unless the option to tax has been exercised.

Key Term: Zero-rated supply
A taxable supply on which VAT is charged at 0%. The sale or long lease of a new residential property by a developer is zero-rated.

Key Term: Standard-rated supply
A taxable supply on which VAT is charged at the standard rate (currently 20%). The sale or lease of a new commercial property (less than three years old) is standard-rated, as is a commercial property where the seller has opted to tax.

Key Term: Taxable supply
Any supply that is not exempt. It includes standard‑rated and zero‑rated supplies.

Key Term: Taxable person
A person or business registered for VAT that makes taxable supplies. Registration is compulsory if taxable turnover exceeds the statutory threshold (£85,000 at present).

Key Term: Output VAT
VAT charged by a business on supplies it makes.

Key Term: Input VAT
VAT charged to a business on goods and services supplied to it; recoverable only if attributable to taxable supplies.

VAT in Property Contracts: Core Principles

VAT Status of Property Transactions

The VAT treatment of a property transaction depends on the type of property and the parties’ actions. Correct categorisation drives pricing and drafting.

• Residential property sales/long leases by developers are generally zero‑rated; subsequent residential sales and lets are usually exempt.
• Commercial land supplies are split by age and option to tax: new commercial property (less than three years old) is standard‑rated; older commercial property is exempt unless the owner has opted to tax.
• Grants of commercial leases are exempt unless the landlord has opted to tax; if VAT is chargeable on rent, s.89 VATA may affect post‑grant changes.
• Mixed‑use transactions require clear apportionment of price and VAT status.

Exam Warning
Do not conflate zero‑rated and exempt. Zero‑rated supplies are taxable (VAT at 0%) so input VAT on associated costs can be recovered; exempt supplies are outside VAT, so input VAT recovery is blocked.

Residential Property

• The sale or lease of existing residential property is VAT-exempt.
• The sale or long lease (over 21 years) of a new residential property by a developer is zero-rated.
• Short-term residential lets (e.g. holiday accommodation) may be standard-rated.
• Renovations or conversions may attract a reduced VAT rate (5%) if certain conditions are met. Construction services for new dwellings are generally zero-rated; professional/legal services are standard‑rated.

Commercial Property

• The sale or lease of an existing commercial property is VAT-exempt unless the seller/landlord has opted to tax.
• The sale or lease of a new commercial property (less than three years old) is standard-rated.
• The option to tax brings a previously exempt property into the VAT regime, making supplies standard-rated.
• Construction/refurbishment services are standard‑rated; opting to tax may be exercised to recover the associated input VAT.

Mixed-Use Property

• If a property is part residential and part commercial, the price and VAT must be apportioned.
• The residential part is usually exempt or zero-rated; the commercial part may be standard-rated if the option to tax applies.
• The apportionment should be evidenced and commercially sensible; HMRC may challenge artificial splits. Note that SDLT/LTT is calculated on the VAT‑inclusive consideration for taxable parts.

The Option to Tax

The option to tax is a formal election by a property owner to charge VAT on supplies of land or buildings that would otherwise be exempt.

Key Term: Option to tax
A formal election by a property owner to charge VAT on supplies of land or buildings that would otherwise be exempt. Once exercised, it generally lasts for 20 years and must be notified to HMRC.

Procedure and Effect

• The owner must notify HMRC of the option to tax within 30 days of making the decision.
• Once exercised, the option applies to all future supplies of that property for 20 years.
• The option can only be revoked in limited circumstances after the statutory period or where anti‑avoidance conditions are met.
• The option to tax does not apply to residential property or certain other exempt supplies. It applies on a property‑by‑property basis and is personal to the person opting.

Practical Impact

• The seller/landlord can recover input VAT on costs related to the property (e.g. development, refurbishment, professional fees).
• The buyer/tenant must pay VAT on the purchase price or rent if the option to tax applies.
• VAT‑sensitive buyers/tenants (e.g. banks, insurers) who make exempt supplies cannot recover input VAT and may seek a price reduction, VAT‑inclusive pricing, or insist the seller does not opt.

Key Term: VAT-sensitive business
A business that makes only exempt supplies (such as banks, building societies, and insurance companies) and therefore cannot recover input VAT.

Transfer of a Going Concern (TOGC)

• If a property is sold as part of a property letting business (e.g. a let building), and both parties are VAT-registered, the sale may be treated as a TOGC and outside the scope of VAT (no VAT charged, SDLT/LTT assessed on the price alone).
• Typically, the buyer must opt to tax (and notify HMRC) prior to completion to ensure continuity of a taxable letting business.
• The contract should specify what happens if TOGC treatment is not achieved (e.g. VAT becomes payable in addition to price, allocation of duty, indemnities).

Key Term: Transfer of a going concern (TOGC)
A transfer of a business that continues seamlessly after the sale; when conditions are met, the transfer is outside the scope of VAT and no VAT is charged on the price.

VAT Clauses in Property Contracts

It is essential for the contract to address VAT clearly to avoid disputes and unexpected liabilities.

Key Term: VAT clause
A contract provision specifying whether the price is inclusive or exclusive of VAT, who is responsible for paying VAT, and what happens if VAT becomes chargeable.

Key Term: Standard Conditions of Sale (SC)
The general conditions used primarily in residential transactions. SC 1.4 states the price is inclusive of VAT unless otherwise agreed.

Key Term: Standard Commercial Property Conditions (SCPC)
The general conditions used in commercial transactions. SCPC 2 contemplates standard‑rated supplies and requires the buyer to pay VAT in addition to price where VAT is chargeable.

Key Term: SCPC Part 2 condition A1
An optional condition that disapplies SCPC 2, provides that the sale does not constitute a taxable supply, and requires the seller not to opt to tax before completion, while allowing VAT to be charged if the law changes between exchange and completion.

Key Points for Drafting

• State whether the price is inclusive or exclusive of VAT.
• Specify the VAT status of the property (e.g. exempt, zero-rated, standard-rated, option to tax exercised).
• Require the seller to provide evidence of the option to tax and HMRC notification if relevant.
• Address what happens if VAT becomes chargeable after exchange but before completion (e.g. due to a change in law or exercise of the option to tax).
• Include indemnities for unexpected VAT liabilities and define who bears any SDLT/LTT consequences if VAT bites.
• For TOGCs, set out the conditions for TOGC treatment and what happens if they are not met.
• Ensure VAT invoices will be issued where VAT is chargeable so that the payer can account for and potentially recover VAT.

Key Term: s.89 VATA 1994 (rent VAT)
A statutory rule that may permit rent to be increased by the amount of VAT where a landlord opts to tax after the grant of an exempt lease, unless the lease makes the rent expressly inclusive of VAT.

Worked Example 1.1

A developer sells a new residential flat and a ground-floor shop in the same building to an investor. The developer has opted to tax the shop.

Question: What is the VAT treatment and how should the contract deal with VAT?

Answer:
The flat is zero-rated (no VAT charged), while the shop is standard-rated (20% VAT applies). The contract should apportion the price, specify the VAT status of each part, and state whether the price is inclusive or exclusive of VAT. The seller should provide evidence of the option to tax for the shop. The duty calculation (SDLT/LTT) for the shop will be on the VAT‑inclusive amount.

Worked Example 1.2

A company sells a five-year-old office building and has previously opted to tax. The buyer is a VAT-registered business.

Question: What is the VAT position, and what if the buyer is not VAT-registered?

Answer:
The sale is standard-rated (20% VAT applies). If the buyer is VAT-registered and uses the building for taxable purposes, it can recover input VAT. If the buyer is not VAT-registered or makes exempt supplies, it cannot recover VAT and may seek a price reduction or VAT‑inclusive pricing.

Worked Example 1.3

A landlord sells a let office building and both parties want TOGC treatment to avoid VAT on the price. The buyer is VAT‑registered and intends to continue letting.

Question: What conditions and drafting points secure TOGC treatment?

Answer:
Ensure both parties are VAT‑registered; the buyer must opt to tax the property (and notify HMRC) prior to completion; the letting business must continue without interruption. The contract should include warranties/conditions precedent for TOGC, require evidence of the buyer’s option and notification, and provide that if TOGC fails (e.g. notification defect) VAT will be payable in addition to the price and the parties will address SDLT/LTT on the VAT‑inclusive amount.

Worked Example 1.4

A landlord granted an exempt commercial lease (no option to tax at grant). Two years later the landlord opts to tax. The lease is silent as to VAT.

Question: Can the landlord start charging VAT on rent and how should leases/agreements address this?

Answer:
s.89 VATA may permit rent to be increased by the amount of VAT where the landlord opts after grant, unless the parties agreed in the lease that rent is VAT‑inclusive or otherwise restricted. In drafting, include a VAT rent clause allowing VAT to be charged in addition to rent where the landlord has opted to tax, and oblige the landlord to issue VAT invoices.

Worked Example 1.5

An old commercial freehold is being sold under SCPC. The seller has not opted to tax but wants protection if VAT law changes between exchange and completion.

Question: What clause manages this risk and what happens if law changes?

Answer:
Include SCPC Part 2 condition A1. It commits the seller not to opt and disapplies SCPC 2, but allows VAT to be charged (in addition to price) if a change in law makes the sale taxable between exchange and completion. The contract should also deal with who bears any SDLT/LTT impact if VAT becomes chargeable, and require issue of a VAT invoice.

Worked Example 1.6

A mixed-use building (two flats and one shop) is sold as an investment. The shop is opted; the flats are residential.

Question: How should the price and VAT be handled?

Answer:
Apportion the price between the shop (standard‑rated) and flats (exempt or zero‑rated if new and by developer). State clearly whether each apportioned price is inclusive or exclusive of VAT, require a VAT invoice for the shop portion, and record any evidence of zero‑rate status for the flats. Remember duty is calculated on the VAT‑inclusive consideration for the opted shop.

Exam Warning

If the contract is silent on VAT, the price is deemed to be inclusive of VAT. This may leave the seller out of pocket if VAT becomes chargeable after exchange. Always ensure the contract expressly deals with VAT.

Exam Warning
Check rent VAT clauses. If the lease states rent is inclusive of VAT, s.89 VATA will not allow the landlord to add VAT later. If rent is exclusive, VAT can be added following an option to tax, and the tenant must budget for the extra cash‑flow.

VAT and Exchange of Contracts

VAT liability is determined by the status of the property and the parties’ actions at the time of supply, which is usually completion. However, the contract may be exchanged before all VAT issues are resolved.

• If the seller exercises the option to tax after exchange but before completion, VAT may become chargeable. Use SCPC Part 2 condition A1 (for commercial contracts) to prevent a seller opt prior to completion while preserving protection if law changes.
• The contract should specify what happens if VAT becomes chargeable after exchange, including who bears the cost, SDLT/LTT impacts, and whether the buyer can withdraw (rare in practice; more often parties agree VAT will be payable in addition to price).
• If the law changes between exchange and completion, the contract should state whether the buyer must pay VAT in addition to the price and require the issue of a valid VAT invoice so that VAT is properly accounted for.
• Consider simultaneous exchange and completion where VAT uncertainty cannot be resolved pre‑exchange; otherwise embed clear VAT risk allocation and evidence requirements (option notifications, TOGC conditions).

Revision Tip
Always check the VAT status of the property and the parties’ intentions before exchange. Obtain evidence of the option to tax and HMRC notification where relevant. Confirm whether the parties intend TOGC, whether the buyer must opt and notify HMRC pre‑completion, and whether SDLT/LTT will be calculated on VAT‑inclusive amounts. Identify VAT‑sensitive counterparties early and adjust pricing/conditions accordingly.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• VAT status depends on the type of property and the parties’ actions.
• The option to tax brings an exempt commercial property into the VAT regime.
• The contract must clearly state whether the price is inclusive or exclusive of VAT.
• Always require evidence of the option to tax and HMRC notification if relevant.
• For mixed-use properties, apportion the price and specify the VAT treatment for each part.
• The contract should address what happens if VAT becomes chargeable after exchange.
• Indemnities and clear VAT clauses protect both parties from unexpected VAT liabilities.
• Use SC 1.4 and SCPC 2 appropriately; consider SCPC Part 2 condition A1 to manage VAT risk.
• Be aware of s.89 VATA for rent where option to tax is exercised after grant.
• For TOGCs, set out and evidence the conditions and agree consequences if TOGC fails.
• Duty (SDLT/LTT) is calculated on VAT‑inclusive consideration where VAT applies.

Key Terms and Concepts

• VAT-exempt supply
• Zero-rated supply
• Standard-rated supply
• Taxable supply
• Taxable person
• Output VAT
• Input VAT
• Option to tax
• VAT clause
• Standard Conditions of Sale (SC)
• Standard Commercial Property Conditions (SCPC)
• SCPC Part 2 condition A1
• VAT-sensitive business
• Transfer of a going concern (TOGC)
• s.89 VATA 1994 (rent VAT)