The VAT implications of leasehold improvements
11 April 2013
Posted by: Author: Doria Cucciolillo
Source: Doria Cucciolillo
property is leased out to a person who makes improvements to such property,
certain Value-Added Tax (VAT) implications may arise. A lessee may be obliged,
in terms of a rental agreement, to make improvements to property that belongs
to the lessor or the improvements can be made voluntarily. In return, the
lessee will normally receive the right of use of such property for a specified
period of time. The purpose of this article is to investigate the VAT effects
of leasehold improvements for both the lessee and the lessor.
For purposes of
this article, it is important to understand the meaning of improvements. Improvements
entail alterations to existing structures and are of such nature that it
becomes a permanent part of the asset or property to which it is effected.
Therefore it must be distinguished from fittings which is only attached to
property and can be removed when the lessee evacuates the premises. The latter normally
represent individual assets which remain the property of the lessee. Furthermore,
a non-removable alteration to an existing structure will only qualify as an
improvement if it does not constitute a repair.
motivations can exist behind a decision to make improvements to property that
belongs to another person. A lessee may, for example, be obliged in terms of
the lease agreement to make certain improvements to the leased property. On the
other hand, improvements may be erected in order to enable the lessee to carry
on its business. For example, in the Rex
Tearoom Cinema (Pty) Ltd v CIR-case the leased premises were unsuitable to
be used for the purpose of a bioscope and extensive alterations had to be
Another example of improvements is where the lessee enters into a lease with a
landowner (to acquire land with no buildings) and the premises are developed by
erecting new buildings on the land. In the Erf
3183/1 Ladysmith (Pty) Ltd v CIR-case it was established that such buildings
improvement becomes permanently attached to the leased property, the lessor
becomes the owner of such improvements. In return, the lessor provides the
lessee with the right to access and use the leased property for the duration of
the lease agreement. The lessor may agree to compensate the lessee for
improvements that were made through an additional monetary payment which is normally
payable on termination of the lease.
Let us first
consider the VAT implications of leasehold improvements from the lessee’s
perspective. In the situation where a lessee (who is a registered VAT vendor)
rents property which is used to make taxable supplies, any improvements made to
such property (whether it is made voluntarily or as a result of a legal
obligation) will constitute a supply (to the lessor) for VAT purposes.
constitute the "goods” that are supplied to the lessor. Since it is required
that a supply must be made in the course or furtherance of the lessee’s
enterprise, the lessee must receive some form of consideration for the
leasehold improvements. In this instance, the market value of the leased
property will represent the consideration for the supply (the lessee makes a
payment of rent in kind in exchange
for the right of use of the lease property) together with any additional
payments received from the lessor in this regard.
there must be a connection between the improvements that were erected and the
activities of the lessee to make taxable supplies. If the improvements relates
to property that is used to make non-taxable supplies (for example private
usage or the supply of residential accommodation which is an exempt supply) the
improvements will not constitute a supply for VAT purposes.
From the above
it is evident that a supply (to the lessor) takes place for VAT purposes when
improvements are made to the leased property. Therefore the lessee has to
account for output tax on the transaction.
The next issue
that needs to be considered is the tax period in which the lessee has to
account for the output tax. Improvements do not constitute a supply of fixed
property since the supply does not include the land on which the property is
situated. Therefore the time of supply rules that relates to fixed property is
not relevant in this situation. The accounting basis that the lessee is
registered on will indicate when the supply occurred. If the lessee is
registered on the invoice basis, he will need to account for VAT as soon as the
lease agreement is concluded since VAT implications are triggered at the
earliest of receipt of payment or issuance of a tax invoice. In this scenario,
the lease contract represents the tax invoice and therefore the supply is made
on the date that the agreement becomes effective.
Since the consideration for the supply
constitutes a right of usufruct and not a monetary amount, there will be no
payment to trigger a supply if the lessee is registered on the payment basis.
Therefore, no output tax obligations will result from the transaction in this
instance. However, if the lessee receives any monetary compensation for the
leasehold improvements he has to account for output VAT thereon.
In the instance
where the parties are connected to each other, the supply will occur as soon as
the goods are made available to the lessor. Therefore the supply will take
place when the items are attached to the permanent structure of the property.
value of the supply must be determined. Since the consideration for the supply
constitutes the right of use of property, the open-market value of such
property on the date of the supply needs to be determined. This amount will
represent the consideration for the supply and will be used to calculate output
tax on the supply. Output tax is also payable on additional compensation
received in the form of a monetary amount.
The lessee will
be entitled to an input tax deduction which is based on the market value of the
improvements. In effect, the latter represents the consideration paid in kind (on which the lessor would have
levied VAT if he or she is a registered vendor)to obtain the right of use of the leased property. The input tax
deduction is apportioned to the extent that the leased property is used by the
lessee to make taxable supplies. Furthermore, an input tax deduction is only
allowed if the property is obtained from a lessor who is a registered vendor
for VAT purposes.
In addition the lessee
will be allowed to claim an input tax deduction on the construction costs of
the improvements. If these costs were incurred to improve property that is used
in by the lessee to make taxable supplies, an input tax deduction is available (to
the extent taxable supplies are made) provided that the lessee is in possession
of the relevant tax invoices.
If the lessor is
a registered VAT vendor, he has to account for output tax on the transaction. A
supply is made by the lessor since he or she grants the lessee with the right
to use the lease property (whether the improvements were made voluntarily or as
a result of an obligation). The consideration for the supply will be the market
value of the improvements (which is received in exchange for granting the right
of use of property). Therefore, the output tax calculation will be based on the
market value of such improvements. Presumably, the open-market value to which
the improvements are expected to amount when completed, will be used.
The time of
supply will depend on whether or not the leasehold improvements were required
in terms of the lease agreement. In this instance, the lessor must account for
output tax on the date (as stipulated in the lease agreement) on which the lessee
becomes liable to erect the improvements. If the invoice basis is applicable
and improvements were made voluntarily, the lessor will be liable for output
tax during the tax period in which a tax invoice is issued. Registration on the
payment basis will not result in any output tax obligations for the lessor
since there will be no payment to trigger output VAT.
If the lessor
enters into a lease agreement with a connected person, the supply takes place
as soon as the property is made available to the lessee. Therefore, output tax
must be accounted for during the tax period in which the lessee is granted
access to the leased property.
An input tax
deduction will be available to the lessor if the improvements were acquired to
make taxable supplies. Therefore, the property, on which improvements were made,
must be let out for commercial (and not residential) purposes in order to
qualify for an input tax deduction. The cost of the improvements is the market
value of the property in which the lessee acquires a right to use. Therefore
the lessor can claim an input tax deduction based on the market value of the
property on the date of the lease agreement. If an additional monetary payment
was made to finance the improvements, input may also be claimed on that.
It is clear from
the above that certain factors need to be considered before the VAT
implications of leasehold improvements can be determined. It is important to
note that VAT implications will only arise if a lease does not constitute the
lease of residential accommodation (which is an exempt supply). In such
instance there will be no VAT effects for both parties. Furthermore, both the
lessee and the lessor must be registered VAT vendors and the property must be
used by the lessee to make taxable supplies.
In a transaction
that involves leasehold improvements, both the lessee and the lessor supply
goods in exchange for a consideration that does not represent a monetary amount.
Therefore, both parties must account for output tax on the market value of the
goods acquired. If the lessee fully erected the property in which it acquired
the right of use, the consideration of both supplies will be equal since it
relates to the market value of the same property. However, it must be noted
that any additional monetary consideration paid by the lessor, can increase the
consideration of the lessee’s supply. It may also happen that a lessee does not
erect the property in full but only improved the property to a certain extent.
In a situation like this, the supply made by the lessor will be limited to the
market value of such improvements.
Finally, one must
keep in mind that the VAT system is driven by tax invoices. An input tax
deduction is therefore only allowed if the recipient of goods is provided with a
valid tax invoice. In this instance, the lease agreement will qualify as such,
provided that it contains the details of the exchange transaction. If the
improvements are voluntarily effected, both parties (the lessee and the lessor)
need to issue tax invoices for the respective supplies in order for the
transaction to attract VAT. Parties registered on the invoice basis will become
liable for output VAT during the tax period in which the tax invoice was
issued. The recipient of the supply will be entitled to claim an input tax
deduction based on the information provided on such tax invoice.
[i] Rex Tearoom Cinema (Pty) Ltd v CIR 1946 TPD 338, 14 SATC 76
3183/1 Ladysmith (Pty) Ltd v CIR 1996 (3) SA 942 (A), 58 SATC 229