What Is Meant By The Disapplication Of The Option To Tax?

What Is Meant By The Disapplication Of The Option To Tax?
I often get queries about the option to tax being disapplied. The following is a common scenario: 



Mr A runs a successful engineering business and bought new premises, an old warehouse costing £500,000, 4 years ago through his pension fund.  He was charged VAT when he bought it and was advised by his accountant that to get the VAT back he should register his pension fund for VAT, opt to tax the property and then charge VAT on the rent to his company.  The company could claim back all its VAT so it was no real cost to them. So that’s what he did.


Since the recession his business has slowed down and he wants to sell up and move to smaller premises.  To help get a sale he has obtained planning permission to convert the factory into residential apartments.

After a couple of months on the market a developer approaches him and makes an offer for the property and says he intends to take advantage of the planning permission and convert the property into luxury apartments.  All looks rosy for Mr A until the developer gives him form VAT 1614D and says that his option to tax is no longer valid and that he should not charge him VAT. 


Mr A sees his accountant and he confirms that if a commercial property is being converted into residential use the option to tax can be disapplied and no VAT is charged on the sale.  From the developer’s point of view he does not want to fund a bank loan on the VAT amount for three months (if the bank will even lend it to him), plus he has to pay stamp duty land tax (SDLT) on the VAT amount as well.    Because the option to tax is disapplied the sale becomes an exempt supply.


As the sale becomes an exempt supply, Mr A cannot recover any of the VAT associated with the sale.  Worse is to come, because as the property cost more than £250,000 it comes under the Capital Goods Scheme which means that if there is a change of use from exempt to taxable or taxable to exempt within 10 years of its purchase then you have to adjust the amount of VAT originally claimed. 


In this case the property cost £500,000 and there has been a change of use within the 10 year period from taxable rentals to an exempt sale.  As the change of use has occurred in the 4th year he is going to have to repay some of the VAT on the original purchase.  In this case the VAT was £87,500 (£500,000 x 17.5%) and the change of use has occurred within year 4 so £52,500 (£87,500/10 x 6) will have to be repaid to HMRC.


Practical Tip:

There is not much that can be done in these circumstances so it is important to take professional advice before you undertake any property transaction so that at least it won’t come as a nasty shock, or even worse you only find out about it when you have a VAT inspection and you get a penalty and interest as well.  At least you know that an adjustment is necessary and can build it into your calculations when setting the price.


You could also decide to demolish the property before the sale as the option can only be disapplied on the conversion of a property not on the sale of bare land.  Alternatively you may be able to come to an agreement with the purchaser and pay his extra SDLT costs as they will be less than the VAT that would be disallowed.


Andrew Needham