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Significant changes to Irish VAT and property legislation commercial property transactions from 1st July 2008.

The new VAT on Property rules, effective from 1st July 2008, will have a major impact on commercial property transactions with implications for both landlords and tenants. Current VAT and property legislation has long been regarded as overly difficult and burdensome and, in some instances, has led to the use of structures aimed at circumnavigating potential irrecoverable VAT costs.

MAIN CHANGES Under the new VAT on Property rules, the sale of new buildings and transformed buildings will be liable to VAT when sold within the first five years of having been completed. Subsequent sales of such properties will also be subject to VAT where the supply takes place within the five-year window and the property disposal takes place within two years of first occupation. These rules will also apply to freehold-type lease, such as leases of 999 years.

FREEHOLD EQUIVALENT The rules introduce a new concept of ‘freehold equivalent’. It is generally clear when a freehold is being supplied. A ‘freehold equivalent’ is essentially a very long lease. It relates to transfers in substance of freehold rights including those where 50% or more of the open market value of a property is transferred and paid for over a period of up to 5 years, for example a 500-year lease with a premium. Where the Freehold (or its equivalent) is supplied, then the supply of the property will be exempt from VAT if supplied outside of the first 5 years.

TRANSACTIONS WITHIN THE FIRST 5 YEARS OF DEVELOPMENT OR REFURBISHMENT Where a property is supplied within the first 5 years of development or refurbishment, the supply will be VATable. If the property is a newly developed property the life of the property for Capital Goods Scheme (CGS)1 purposes will be 20 years. If the property has been refurbished, the VAT life of the property will be 10 years. The supplier’s inputs will be determined in accordance with his use of the property during the VAT life of the property and in accordance with the CGS.

TRANSACTIONS WHERE PROPERTY HAS BEEN OCCUPIED FOR 24 MONTHS However where the property has been supplied once already and has been occupied for 24 months the subsequent supply of the property is exempt from VAT unless the supplier and purchaser jointly exercise an option to treat the supply as VATable. The advantage of exercising the option is that the supplier may retain his VAT input credits, or if he was not entitled to VAT inputs originally, may now recover a portion of the inputs denied him on the basis of the CGS.

PROPERTY SUPPLIED OUTSIDE OF THE FIRST 5 YEARS Where the property is supplied outside of the first 5 years, the supply is exempt unless there has been some material development in the property. If there has been no material development of the property in the 5 years immediately prior to the supply, while the property is exempt, the supplier and the purchaser may jointly exercise an option to treat the supply as a VATable supply.

REFURBISHED OR DEVELOPED PROPERTY Where the property is supplied outside of the first 5 years immediately after the development and there has been development/ refurbishment of the property in the 5 years immediately prior to the supply, the status of the supply for VAT purposes depends on whether the development has materially altered the use, and if it has done so, was the expenditure on the development equal to or greater than 25% of the sales proceeds? Where there is no materially altered use, or where expenditure of less than 25% of the sales proceeds was spent on the development, the supply is an exempt supply. However, it is possible for the supplier and the purchaser to exercise a joint option to treat the supply as VATable.

NEW / NEARLY NEW Example: In August 2008 Jack builds an office block. On 31 December 2008 he sells it for €2m to Jill. Jack must charge 13.5% VAT on the sale and raise a VAT invoice. The office block is a capital good for Jill.

Jill has bought the property to use it for her PR Business. She occupied two thirds of the property but the remainder was vacant. In January 2011 she decides to sell the building to Mark.

Part of the property is ‘new/nearly new’ and Jill must charge 13.5% VAT on that part of the consideration. Part of the property is ‘unnew’ and therefore exempt with option to tax (EWOTT).

SECOND-HAND PROPERTIES The sale of second-hand properties will not be subject to VAT and properties will become exempt from VAT with the passage of time. To counteract any potential claw-back of VAT as a result of making an exempt supply, the parties will be permitted to opt to tax the sale. Such an option will be exercised jointly by the vendor and purchaser. This option to tax will be on a property by property basis and this is a welcome development as it gives landlords some flexibility in dealing with their property portfolios. Property that is not ‘new/nearly new’ is EWOTT.

Example: In August 2002 Mary bought a commercial building which she fully used for her solicitor’s practice. VAT of €200,000 was charged on the purchase and reclaimed. No works have been carried out on the property since its purchase. Mary sells the property for €3 million in October 2008 to Joe, who will use it as offices for his accountancy practice. The property is unnew and EWOTT.

Mary and Joe opt to tax the sale.

Joe’s VAT return would look as follows: Input VAT €405,000 Output VAT €405,000 The property is a capital good for Joe.

This will cause difficulties for vendors who are selling properties to entities which are VAT exempt. The purchaser may not wish to opt to tax the sale as it will lead to irrecoverable VAT for it. This could mean that the sale would fall through, with various financial consequences: the vendor may have to suffer the VAT costs of any clawback, or the vendor may have to seek a higher sales consideration, thus leading to dual pricing in the market depending on the VAT status of a purchaser. This cannot surely be a welcome development, and will be a prima facie distorting of the property market by VAT legislation.

LEASEHOLDS/SHORT-TERM LETTING – MAJOR CHANGE Unlike the older VAT rules, the letting of a property is an exempt supply, regardless of the duration of the lease. However, the supplier may exercise an option to treat the supply as a VATable supply in certain circumstances. The option cannot be exercised in relation to residential property in any circumstances. The letting of property will be exempt from VAT regardless of the terms of the lease granted by a landlord. This creates a VAT problem for landlords since exempt supplies do not give rise to an entitlement to reclaim VAT on the purchase or construction of a property. To counteract this, an option will be available to tax the rental income at 21%. This option to tax can be exercised by the landlord alone, and can be availed of where the parties are not connected. The definition of ‘connected person’ is drawn broadly and leases between connected persons will be exempt from VAT except in certain, very specific, situations. The real hidden tax trap is what happens after a commercial lease is put in place. A landlord may elect to tax a lease – though this is not an issue if the tenant can recover this tax charge. However, many businesses – Banks, Insurance Companies and Bookmakers, for example – are VAT exempt.

CAPITAL GOODS SCHEME The capital goods scheme (CGS) is a key feature of the new VAT rules and is provided for in the new Section 12E introduced by Section 98 FA 2008. The concept is common in the VAT systems of other European countries. Under the new rules, each property has a VATable life or adjustment period’ of either 10 or 20 years. The adjustment period is 20 years in the case of a new development, or 10 years in the case of a refurbishment. The CGS has a major impact on the input credits for the supplier. In effect, once a taxpayer acquires or develops a property and incurs inputs, the taxpayer may recover the VAT inputs immediately provided that the property is put to a VATable use and to the extent that the property is put to a VATable use.

Intervals The CGS divides the inputs reclaimed into the relevant number of intervals. In the case of a new build there are 20 intervals representing each year of the adjustment period for that property. In the case of a refurbishment there are 10 intervals. The initial interval runs from the date that the property was completed or acquired to 12 months from that date. The second and subsequent intervals run from that date. The importance of the initial interval is that it is used as a base period against which the VAT usage in all the subsequent intervals is measured. While the inputs are recovered immediately at the time that the property is acquired or developed, the availability of the inputs is then reviewed at the end of each interval on the basis of what use was made of the property during that interval. The VAT usage of the property during any interval is compared to the VAT usage of the property during the initial interval. If the VATable usage of the property during an interval is different to the VAT usage of the property during the initial interval, an adjustment for VAT purposes may be required, resulting in either a payment of VAT to Revenue or an additional refund of VAT.

Example: Tom is a Pharmacist. On 1 Jan 2009, Tom purchases a commercial retail unit in Limerick for €1m + VAT (€135,000). Due to the nature of his business, Tom is entitled to reclaim 10% of VAT

Initial VAT Deduction €13,500 (€135,000 * 10%) Non deductible portion €121,500 (€135,000 * 90%) Adjustment Period 20 Intervals (from 1 Jan 2009)

In 2012 (during 4th Interval), Tom has 15% VAT recovery. Reclaim difference from Revenue

Example 2: On 31 Jan 2013 (during 5th Interval), Tom sells the retail unit to Jim (fully taxable) for €2m + VAT (270,000) who uses it for his auctioneering business.

For Tom: Repayable by Revenue to Tom – €121,500 * 15/20 = €91,125

For Jim: Initial VAT deduction €270,000 Adjustment Period 20 Intervals (from 31 Jan 2013)

However, at some time in the future, the tenant may surrender the lease and, if the landlord cannot find another tenant who is also agreeable to pay the 21% VAT on rents, he is likely to face a significant VAT clawback. Similar pitfalls face the landlord if the tenant wishes to assign his lease to an assignee who is reluctant to pay VAT on rents. And it is not plain sailing for tenants either. Given the significant risk of a major VAT hit for landlords, leases are likely to be drawn up with very detailed VAT clauses. Perhaps there is a need to have a scheme that will track the extent to which the property is put to a VATable or exempt purpose but this will add to the complexity of the rules and the operation of the scheme. Detailed record keeping on a property by property basis by both landlords and tenants will be necessary. The VAT clawbacks can occur for tenants and property owners and will require very careful and active management of the property by the various parties in order to minimise potential VAT liabilities. No landlord wants a tenant to be able to vacate a property leaving the landlord with a potentially crippling VAT bill. The landlord will expect his solicitor to draft a lease that protects him from that eventuality. This will give rise to disagreements between landlord and tenants over lease terms, and will add further delays to closing deals.

TRANSITIONAL MEASURES There are a detailed raft of transitional measures designed to bridge the gap between the new rules and old rules. The transitional rules apply to interests of 10 or more years created prior to and held at 1 July 2008 or property which has been acquired or developed prior to 1 July 2008 but which has not been disposed of by that date (‘transitional properties’).

Freehold/Freehold equivalent sales of properties acquired or developed prior to 1 July 2008 will be exempt from VAT if the seller was not entitled to recover VAT on the acquisition or development of those goods. The seller and purchaser may however agree to opt to tax the sale.

Leasehold interests granted in properties that the lessor acquired or developed prior to 1 July 2008 will be exempt from VAT if the seller was not entitled to recover VAT on the acquisition or development.

Where a person grants a lease of a transitional property and they had recovered VAT on the acquisition or development of that property, there will be a clawback of some of the VAT recovered.

Where a leasehold interest held at 1 July 2008 is subsequently surrendered or assigned then that surrender or assignment will be taxed in a similar way as under the existing rules if it would in fact have given rise to a tax charge under the existing rules. The taxable amount will however be different. The interest will then become a Capital Good in the hands of the landlord/assignee.

A change in use of transitional properties will not give rise to a Capital Goods Scheme adjustment unless the property is sold or let by the owner. An exempt sale or lease could give rise to an adjustment under the scheme.

Waivers of exemption in place on 1 July 2008 shall remain in force unless the parties to the letting are connected parties. A waiver between connected parties will be disapplied unless that VAT paid on the rent under the letting agreement satisfies a minimum threshold calculated in accordance with a legislative formula.

CONCLUSION We were promised a simpler system of VAT but the implementation of the new rules has been likened to having a toothache. You will have to go to the dentist and suffer some immediate pain, but in the long run it will be better for you. Time will tell whether the new regime will meet the simplification objective or whether we are replacing one unwilling white elephant with a new raft of tax definitions and idiosyncrasies that will confuse and confound business, practitioners and Revenue alike. Either way, there are challenges ahead for all as we get to grips with the new regime.