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

Learning Outcomes

After reading this article, you will be able to identify and explain the VAT implications of property contracts for both residential and commercial transactions, including the effect of the option to tax, the distinction between zero-rated, exempt, and standard-rated supplies, and how to draft and interpret VAT clauses in contracts. You will also be able to apply these principles to SQE1-style scenarios and avoid common pitfalls.

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. In your revision, focus on:

• 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

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. For SQE1, you must be able to identify when VAT is chargeable, how the option to tax operates, and how to ensure the contract properly addresses VAT risks. 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.

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.

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.

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.

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.

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 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.
• The option to tax does not apply to residential property or certain other exempt supplies.

Practical Impact

• The seller/landlord can recover input VAT on costs related to the property.
• The buyer/tenant must pay VAT on the purchase price or rent if the option to tax applies.
• Buyers who make only exempt supplies (e.g. banks, insurers) cannot recover VAT and may seek a price reduction.

Transfer of a Going Concern (TOGC)

• If a property is sold as part of a 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.
• The contract should specify what happens if TOGC treatment is not achieved.

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 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.
• For TOGCs, set out the conditions for TOGC treatment and what happens if they are not met.

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.

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.

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.

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.
• The contract should specify what happens if VAT becomes chargeable after exchange, including who bears the cost and whether the buyer can withdraw.
• If the law changes between exchange and completion, the contract should state whether the buyer must pay VAT in addition to the price.

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.

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.

Key Terms and Concepts

• VAT-exempt supply
• Zero-rated supply
• Standard-rated supply
• Option to tax
• VAT clause