Practical guide: Claiming input tax on commercial property purchase

Mixed use of building

The business will be using the building for a dual purpose, and each activity needs to be considered in its own right.

Trading income. The business is partially exempt, generating both taxable and exempt sales, so input tax on the purchase price of £1m plus VAT will be residual input tax as far as partial exemption is concerned, i.e. partly claimable.

Rental income. The starting point is that rental income is exempt from VAT, unless the business opts to tax their interest in the building with HMRC, in which case it will be standard-rated. The option to tax election will therefore increase the input tax that can be claimed on the purchase price because more taxable income is being generated.

An option to tax election will deal with the partial exemption challenge for the rental activity but the use of the building for the business’s own trading means that it cannot be removed entirely. In other words, some of the £200,000 input tax paid on the purchase price will be blocked.

Before opting to tax the building with HMRC, the business should be aware that it cannot be revoked for 20 years, and it will also apply VAT to the sale of the building, which might create a problem for a future tenant or buyer who cannot claim input tax, e.g. a dentist or insurance broker.

Standard method

If the business uses the standard method for partial exemption purposes, the input tax to initially claim on the new building will depend on the proportion of their taxable to total turnover in the tax year it was purchased.

So, e.g. if taxable sales are 60% of total turnover, the input tax to claim will be £120,000, i.e. £200,000 x 60%.

If the residual input tax is less than £400,000 per month on average, which will almost certainly be the case, they will round up the percentage above to the nearest whole number, e.g. 71.1% would mean 72% is claimed.

The amount of input tax initially claimed will depend on the percentage of taxable to total turnover in the VAT period when it is purchased, but quarterly variations are automatically dealt with by an annual adjustment calculation at the end of March, April or May each year, depending on the periods of the business. In other words, it is the annual adjustment that counts because it supersedes any quarterly calculations.

Special method?

Sticking with the 60/40 split above, the input tax claim of £120,000 could perhaps be improved if the business applies to HMRC for a special method for partial exemption purposes, and a square footage method would seem both fair and sensible.

However, it will depend on the percentage of the building that the business will rent out. The bigger the percentage, the more beneficial the special method will be, assuming they opt to tax the property with HMRC. Here is the logic:

• let’s say that the business rents out half of the building, e.g. they rent out the first floor and trade from the ground floor themselves
• if the business opts to tax the property with HMRC, then 50% of the building use is directly linked to taxable sales, i.e. standard-rated rental income
• if the special method used a turnover based calculation for the ground floor part of the building, the trading use, the total input tax claim on the property purchase will be £160,000 (see below)
• the business must apply for a special method as soon as the property is purchased although HMRC will usually allow it to be backdated to the beginning of a tax year
• it can get HMRC’s approval by using the online service .

Input tax to claim = £100,000 (for first floor use) + £100,000 x 60% = £60,000 (for ground floor trading use) = £160,000.

A special method is any method that is not the standard method, so even a small deviation from the standard method is classed as a special method and requires HMRC’s approval. The business must also certify that the proposed method gives a fair and reasonable result in terms of input tax recovery.

The special method should specify that the square footage calculation only relates to expenses that directly relate to the property. All other expenses will apportion input tax based on the usual standard method calculation.

Capital goods scheme

Partial exemption challenges aren’t the end of the story. The purchase price of the property will exceed £250,000 excluding VAT, so the input tax of £200,000 comes within the capital goods scheme (CGS), i.e. the business must adjust their input tax claim each year for the next ten years after it is purchased.

The purpose of the CGS is to adjust input tax on major property projects, including refurbishments, extensions and improvement works that exceed £250,000 excluding VAT, to reflect any change between exempt and taxable use of the building during that period.

Annual adjustment calculations are made up to the end of March, April or May each year, basically reviewing 1/10 of the total input tax each year, i.e. £20,000 per year in our example. If the percentage of taxable use increases compared to the base year, more input tax will be claimed with the annual adjustments, but input tax will be repaid if exempt use increases. The tax owed or owing is included on the VAT return after the end of each tax year which includes 30 September.

Example. It is now the end of year three and the business has changed the use of the building so that 75% is rented out to third party tenants and only 25% is used for their trading activities because more staff work from home. The mix of taxable/exempt sales has also changed from 60/40 to 70/30. How much is the annual adjustment for the CGS?

The initial input tax claim was £160,000, i.e. £16,000 for each year of the CGS. The input tax claimable for year three is calculated as follows:

£20,000 x 75% = £15,000 (for rental activity) plus £20,000 x 25% (for trading activity) x 70% (for taxable trading) = £3,500.

The total claim for the year is £18,500. The extra input tax of £2,500 (£18,500 less £16,000) will be included in the return after year three which includes 30 September (an increase in the Box 4 input tax figure).

The business should review the outcome of each CGS adjustment to ensure it is reasonable. The extra claim of £2,500 looks sensible because the percentage of rental use has increased compared to the base year, and all rental income is taxable because of the option to tax election made when the building was purchased; the percentage of taxable trading sales has also increased from 60% to 70%.