UK: VAT And Service Charges

A current European case is examining whether the provision of services by a landlord to tenants is a VAT-able supply even if the landlord does not charge VAT on the rent.

Before entering into a new lease of commercial premises, the prospective tenant will always want to know, and his lawyers will enquire as part of the pre-contract due diligence process, whether the landlord has "opted to tax" the property – namely, whether it has elected to charge VAT on the rents payable under the lease it is proposing to grant. This includes not only the "principal" rent, but also any other sums which are reserved as "rent" in the lease and this will usually include the sum that has to be paid to the landlord as service charge.

"The Court of Justice of the European Union are now considering the point again and will be making a ruling in due course. This could have implications for tenants and in particular those who have issues over VAT recovery."

Of particular interest to tenants and their advisors in this regard is the new RICS published "Service Charges in Commercial Property Code of Practice (second edition)" which has been in effect since 1 October 2011. While this covers many matters pertaining to service charges, it also discusses the issue of VAT on service charge. Principally, it aims to promote transparency so that tenants know the full position and the extent of their payment obligations before entering into a lease.

VAT election

A landlord may decide to elect (known as "opting" to tax), because he wishes to be able to recover VAT on expenditure related to the property. If the landlord does not so elect, the lease and the rents are exempt from VAT. Most leases of commercial premises include a service charge which allows the landlord to recover from the tenant the cost of services that it supplies. These services range from basic provision of utilities, lighting and heating, maintenance of common parts and so forth to more sophisticated security systems and supplying staff.

The basic view of HM Revenue & Customs is that where a landlord has an obligation to provide services in the building, the cost of which is then charged to the tenants, the charge for those services goes hand in hand with the rent that is charged and accordingly whether there is VAT on the service charge depends upon whether there is VAT on the main rent. Therefore, service charge will be treated for VAT purposes in exactly the same way as the basic covenant to pay rent. If the landlord has elected to tax, he will be able to charge VAT on the service charge. So far, this all seems to make sense.

Field Fisher Waterhouse LLP v HMRC

However, the case of Field Fisher Waterhouse, which has recently been referred to the Court of Justice of the European Union, could have an impact upon whether VAT should in fact always be chargeable upon service charges in leases. The question is whether the provision of services is a separate taxable supply in its own right, or whether it is an element of a "supply to a lease of land" (which will be exempt from VAT unless the landlord has elected to exercise the option to tax).

This follows on from a 2009 decision, also in the European Court, called RLRE Tellmer (Case C-572/07) which found that in a residential block where the rent was exempt from payment of VAT, it should in fact be chargeable on the costs of cleaning, thus introducing the principle that these items could be treated separately rather than following the idea that the two elements are one and the same – "rents" - and therefore should not be treated separately for VAT purposes. A relevant issue was whether the tenant in question had the opportunity to commission the services from a third party. In the case of most commercial leases where a landlord supplies services, a tenant is not free to have this choice. HMRC was not persuaded to change its policy as a result of this case, so in practical terms nothing changed.

The Court of Justice of the European Union are now considering the point again and will be making a ruling in due course. This could have implications for tenants and in particular those who have issues over VAT recovery.

Points to watch

  • If a landlord has not elected, but incurs VAT in providing the services, the landlord may be "hiding" that irrecoverable VAT and charging it to tenants in any event. Tenants who are aware of this could, as Field Fisher Waterhouse have done, consider making a repayment claim to HMRC. It may not work on the basis of HMRC's treatment of VAT outlined above, but with the Field Fisher case in the pipeline, things may change.
  • If such a change were to ensue, tenants may benefit from paying a lower "net" service charge as landlords would be able to reclaim the VAT they incur in providing the services and therefore would not need to charge the "hidden" VAT to tenants.

For tenant clients who may not be able to recover VAT, or make full VAT recovery, whether or not VAT is chargeable on service charges could make a significant difference to their budgeted costs.

  • Agents need to be aware of this at the heads of terms stage so that the parties are clear and, if possible, VAT inclusive service charge provisions may be agreed.
  • Where a "cap" on service charge per square foot is negotiated, the VAT issue needs to be covered at the initial stages of the transaction to ensure that all parties are clear whether the cap is VAT inclusive or exclusive.
  • The drafting in the lease needs to be clear on whether VAT is payable on top of the rents demanded.
  • The most important advice at present is for tenants to be clear on the position, either way, so that if moving into a new building and establishing budgets they know what to expect.
  • Remember that if sub-letting, a tenant needs to make its own decision as to whether or not to elect for the purposes of charging their sub-tenant as the landlord's own VAT election status will not be binding upon a sub-tenant.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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