Changes to the Capital Goods Scheme

United Kingdom

Richard Croker examines the scope for planning opportunities

As widely anticipated, the Government has brought forward some changes to the Capital Goods Scheme under cover of the recent Budget. The interaction of these changes with the new rules on the disapplication of the option to tax contained in the last Finance Act of the previous Parliament extends the impact of these rules on commercial property transactions but also creates one or two legitimate planning opportunities.

In broad terms, the Capital Goods Scheme is designed to ensure that the recovery of VAT on capital costs of property over a certain threshold be made on the basis of the use of that property over a 10 year period. This is contrary to the usual rule that VAT is recovered according to first use. The Capital Goods Scheme bites on purchases or construction at a cost plus VAT of over £250,000. The new rules extend the Scheme to civil engineering works and most significantly to refurbishments or fittings out where the value of the capital expenditure on services and goods affixed to the building on or after 3rd July 1997 is over the £250,000 threshold. This means that old buildings can now come within the Capital Goods Scheme even where they do not change hands.

Surprises

Section 37 Finance Act 1997 operates to disapply the option to tax in certain circumstances. It is an anti-avoidance provision but is rather widely drawn - there is no motive test, as such. Amongst other conditions, the option can only be disapplied where the property is within the Capital Goods Scheme. If a refurbishment brings a property within the Scheme, any grant to a connected person of the landlord or to a tenant who is financing the fit-out and who is also making other than wholly or mainly taxable supplies, will cause the election to be disapplied. This might cause one or two surprises. The effect is to disapply the election in relation to the grant in question (e.g. that particular lease) for its duration, even after the Capital Goods Scheme period of 10 years has ceased. This provides potential planning opportunities bearing in mind that the election is otherwise irrevocable within 20 years. If an exempt tenant is willing to bear the cost of the landlord's irrecoverable VAT on refurbishment costs of £250,000, for that price he can convert an elected building into a non-elected one.

Alternatively a refurbished property can be let to a connected person of the landlord with a subsequent assignment at a premium. The previous anti-avoidance rules created opportunities for disapplying the election. One of the effects of replacing those old rules with the new provisions of section 37 was that de-opting schemes were made more difficult.

The good news is that the changes to the Capital Goods Scheme create more opportunities in this area.

Other planning opportunities

Leases granted before 26 November 1996 are a valuable commodity. The election cannot be disapplied even if the property is within the capital goods scheme. Stop and think before taking a surrender of a pre-26 November lease from a tenant and granting a new lease (perhaps, following a refurbishment or fit-out). If the old lease is not near to expiry, it may be preferable to grant a reversionary lease to the tenant. The same considerations apply to leases granted before 30 November 1999 where the lease was granted pursuant to an agreement executed before 26 November 1996.

Despite the breadth of section 37, there are some anomalies arising from its interaction with the capital goods scheme and other VAT rules such as the provisions dealing with the transfer of a business as a going concern. There may still be opportunities for exempt or partially exempt businesses to mitigate VAT or the cashflow cost of VAT on the capital cost of a new building.

Anti-avoidance

Other changes are not so helpful. Although the anticipated reduction in the capital limit from £250,000 to £100,000 has not been enacted, and the period of the Capital Goods Scheme has not been extended to 20 years, two anti-avoidance provisions are worth noting. In the first place, provisions are enacted to prevent artificial foreshortening of the Capital Goods Scheme period. Another change is to attack an obscure avoidance scheme which involved a sale of the freehold at a reduced price once the value of the freehold had been stripped out by the grant of a long lease at a premium.

In order to counter this, Customs & Excise have provided that the total input tax which can be recoverable under the Capital Goods Scheme cannot in any circumstances exceed the amount of output tax charged on a sale of the capital item within the Capital Goods Scheme period.

This could cause problems for property owners forced to sell at a loss even though there is no avoidance motive. The legislation gives the Commissioners the power to ignore these provisions in such cases, but that is simply a case of untaxing by concession and it is regretted that Customs could not apparently be bothered to require the drafting of more precise provisions. At the very least it is hoped that the Statement of Practice that Customs intend to issue in the first part of August will unequivocally state that these provisions will not apply where the capital item is used only for taxable purposes. Purchasers of property as a transfer of a going concern now have another reason for extracting information from the Vendor about capital items.

Section 37 has raised the profile of the Capital Goods Scheme; any landlord selling or leasing property on which he has incurred capital expenditure of more than £250,000 in the last 10 years will need to make sure that these provisions do not apply, or that if they do, that is what he intends. With the changes to the Scheme bringing more properties within it, the scope for error is increased. Despite planning opportunities, many property owners will see these rules simply as another inconvenience.

It is nearly 10 years since the UK Government bowed to Europe and introduced VAT on commercial property. Almost every year the rules are changed; they have never been more complex than in 1997.