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The VAT implications of leasehold improvements

11 April 2013   (0 Comments)
Posted by: Author: Doria Cucciolillo
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Source: Doria Cucciolillo

When immovable 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. 

Background

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. 

Different 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 carried out.[i] 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 represent improvements.

Since an 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. 

The lessee

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.   

The improvements 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. 

Furthermore, 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. 

Finally, the 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. 

The lessor

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. 

Conclusion

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
[ii]Erf 3183/1 Ladysmith (Pty) Ltd v CIR 1996 (3) SA 942 (A), 58 SATC 229


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