VAT Partial Exemption and the Capital Goods Scheme
Harbour View Developments Ltd is VAT-registered and owns a mixed-use building. The ground floor is let to commercial tenants (taxable), and the upper floors are let to a charity for a nursery (exempt). For the quarter to 30 June 2025, total input VAT was £84,000, of which £30,000 relates directly to the commercial letting, £18,000 relates directly to the exempt letting, and £36,000 is attributable to the whole building (rent, utilities, repairs). The company's taxable turnover for the year is £620,000 and exempt turnover is £410,000. In 2023 the company incurred £1.2m (ex VAT) on a major refurbishment of the building, which it uses for both taxable and exempt supplies. The company has not previously applied the capital goods scheme.
1. Calculate the recoverable input VAT for the quarter and identify any partial exemption method issues.
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Directly attributable:
- Commercial (taxable): £30,000 - fully recoverable.
- Exempt letting: £18,000 - not recoverable.
- Residual (whole building): £36,000 - apportion.
Apportionment: Standard method uses turnover: taxable £620,000 / total £1,030,000 = 60.19%. Residual recoverable = £36,000 × 60.19% = £21,668.
Total recoverable = £30,000 + £21,668 = £51,668. Irrecoverable = £84,000 − £51,668 = £32,332.
Method issues: The company must have an agreed partial exemption method with HMRC (standard or special). The standard method is mandatory unless a special method is agreed; a special method may be more appropriate because floor-area-based recovery better reflects use of the building than turnover (the charity rent may be below market). The de minimis test: exempt input VAT of £32,332 exceeds both £625/month (£7,500/quarter) and 50% of total input VAT, so no de minimis relief. The company should also consider the annual adjustment.
2. Explain the capital goods scheme implications of the 2023 refurbishment and the risk if use changes.
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The refurbishment cost £1.2m (ex VAT), above the £250,000 CGS threshold for land and buildings, so it is a capital item subject to the capital goods scheme over a 10-year adjustment period (2023–2032).
The initial recovery in 2023 would have been based on the proportion of taxable use in that year. Each year, the company must compare the recovery percentage with the actual taxable use and make an annual adjustment: if exempt use increases, VAT must be repaid; if taxable use increases, further VAT is recoverable.
The adjustment for each year = (total VAT on the capital item / 10) × (current year taxable use % − initial recovery %).
Risk: If the charity letting expands (e.g. the commercial tenant leaves and the space is re-let exempt), the taxable use percentage falls and the company faces annual CGS repayments. Because the company has not previously applied the CGS, there is a compliance risk - HMRC can assess for prior years, and penalties may apply for failure to make adjustments. The company should register the capital item, calculate adjustments for 2023–2025, and consider whether the option to tax the charity letting would preserve recovery (subject to the charity's ability to recover VAT).
3. Advise on whether the option to tax should be exercised on the charity letting.
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Exercising the option to tax makes the letting a taxable supply, so input VAT on the exempt-attributable costs becomes recoverable and the CGS adjustments move favourably.
But: The option to tax is ineffective if the charity cannot recover VAT (charities generally cannot recover VAT on property costs), so the VAT becomes an absolute cost to the charity. The charity may resist or seek a rent reduction. Also, the option to tax does not apply to a supply to a person who is a "relevant associate" or where the property is a dwelling; a nursery is not a dwelling, so the option is available.
Practical advice: Model the cash effect - extra VAT recovery (roughly the £18,000 direct plus a share of the £36,000 residual) versus the rent reduction the charity may demand. Consider a "cost-sharing" arrangement or a special method instead. If the option is exercised, notify HMRC within 30 days and keep records. Also consider the anti-avoidance rules (the option is disapplied if the property is within the "option to tax" restrictions for certain exempt bodies). Document the commercial rationale.