The Chancellor of the Exchequer has announced a major change to the VAT option to tax (election to waive exemption), which could affect many commercial property transactions.

The option to tax will be suspended if, and as long as, the tenant (or purchaser, or other recipient of a land supply), does not use the property for mainly taxable purposes.Where the new rules bite, there may be serious adverse repercussions as regards input tax recovery for the supplier, which may mean amendments to conveyancing documents.This article summarises the main impact of the new rules, especially in relation to leases.

The rules will form part of the Finance Act 1997, and the draft legislation, which is set out in cl 35-37 of the Finance Bill, and on which this article is based, may be amended during its course through Parliament.Rationale for the changeVAT-exempt occupiers such as hospitals, schools, banks, insurance companies and dentists cannot reclaim all the VAT on costs such as construction and refurbishment.

In the past, to reduce the impact of irrecoverable VAT, these businesses would sometimes enter into leasing structures to spread the VAT cost, therefore reducing the cash flow cost of the irrecoverable VAT.The government introduced the 'connected persons' rules in November 1994 to attack some of these structures.

But these rules failed and have been repealed for supplies made after 25 November 1996.

The new rules are a further attempt to stop these leasing structures, but as they are not restricted in their application to transactions between connected persons, they will have a much wider impact and could affect ordinary commercial property transactions.Customs intends in principle that VAT should only be recoverable by a landlord or other supplier of land (and accordingly VAT only should be charged) where the underlying use of the property consists to a significant extent of standard-rated or zero-rated business transactions.Application of the new rulesThe new rules will apply to all supplies made after the Finance Act 1997 receives royal assent, which will be in March or April 1997.

They will not affect:-- supplies arising from 'grants' (eg the grant of a lease) made on or before 25 Nov ember 1996;-- supplies arising from grants made on or before 30 May 1997 pursuant to a written agreement entered into on or before 25 November 1996;-- supplies made to government departments, including NHS trusts;-- supplies made for non-business purposes to local authorities and other bodies falling within s 33 of the VAT Act 1994.Effect of new rules on leasesWhere a landlord has opted to tax a property, and grants a lease after 25 November 1996 and the transitional rules referred to do not apply, then whilst the tenant is not registered, or liable to be registered for VAT, or does not use the demised premises at least 80% for making taxable supplies, the landlord's option to tax is suspended, and no VAT is chargeable on the rents.

The new rules affect supplies made after royal assent.

Accordingly, since the 'tax point' rules for rent dictate that the supply takes place when the rent is paid, or the VAT invoice is issued if earlier, the rules will provisionally apply to rent paid or received or invoiced after royal assent.

It should be noted that:-- renewal of leases and variations giving rise to deemed surrenders and regrants by operation of law after 25 November 1996 can be affected;-- to determine whether the tenant's taxable use (or intended use) of the demised premises exceeds the 80% threshold it is necessary to consider only the tenant's use (or intended use) of those premises in the tenant's VAT prescribed accounting period in which the supply occurs.

The tenant's normal input tax recovery rate will usually be irrelevant.

The user test is to be applied on a 'fair and reasonable' basis;-- a tenant who has been using the demised premises for fully taxable purposes but who assigns to an exempt business would cause the rents under the head lease to become exempt.

This would also be the case if the tenant were to sub-let to an exempt sub-tenant;-- any VAT paid in error by the tenant after the option to tax ceases to apply to supplies made to the tenant will be irrecoverable because it is not VAT;-- if the landlord is unable to charge the tenant VAT, the landlord will be unable to recover input VAT incurred in respect of the property.

This is a complex area but in principle the landlord could suffer VAT on service charge items, agents' and lawyers' costs, refurbishment expenditure, and potentially under the capital goods adjustment rules (which Customs proposes to extend to cover refurbishment);-- Customs expects that the parties will agree specific provisions in the lease to cater for the new rules.

In particular, the landlord will want to be kept informed about the VAT status of the tenant's use of the property and in appropriate cases may seek an indemnity for adverse input VAT repercussions arising as a result of the tenant's taxable use of the property falling below the 80% threshold;-- in relation to multi-let buildings, landlords might be charging VAT on leases granted before 25 November 1996, but as a result of the new rules, not on leases granted to some tenants after this date.Other property transactionsSubject to the transitional provisions, the new rules also apply to sales, assignments, surrenders, reverse surrenders and other commercial property supplies to which the option to tax could apply.

Accordingly, even if the supplier has opted to tax, the supply will nevertheless be exempt if the taxable use of the property by the recipient of the supply in his or her relevant VAT accounting period is below the 80% threshold.The role of the property adviser has become more complicated.

For examp le, in advising a purchaser whether VAT is payable (and ignoring the rules on transfer of a business as a going concern), it is no longer sufficient merely to find out if the seller has opted to tax.

Even if the seller has, no VAT will be chargeable if the purchaser's taxable use of the property will be less than 80% in the purchaser's prescribed VAT accounting period in which the supply (generally completion) takes place.

This may not be known on completion, unless the sale takes place at the end of the purchaser's VAT accounting period.

Stakeholder accounts may become more common in practice, as parties seek to protect their respective positions.

The new rules only affect property transactions to which the option to tax can apply.Some believe the proposed changes will create a two-tier property market, with developers being unable to let new buildings to VAT-exempt users because of adverse input VAT repercussions, and exempt users being unwilling to share the VAT hit.The VAT and duties sub-committee of the Law Society's revenue law committee is represented in the land and property liaison group.

It has also been involved in high-level discussions with Customs to express concerns over the proposed changes and the major practical implications they will entail.