VAT implications of leasehold improvements
These have very specific consequences for the lessor and the lessee, specifically with regards to the VAT time and value of supply rules
THE South African Revenue Service (SARS) recently published a draft interpretation note on the Value Added Tax (VAT) time and value of supply rules which apply to leasehold improvements, but without addressing barter type transactions where either the lease premiums or the leasehold improvements are supplied at a value other than the open market value.
The VAT implications of leasehold improvements can be interesting as they have very specific consequences for the lessor and the lessee, specifically with regards to the VAT time and value of supply rules.
An understanding of accessio is necessary to understand the effects of leasehold improvements and the VAT consequences thereof. The concept of accessio has its origin in ancient Roman property law which determined ownership, amongst others, of goods which related to other goods, where it could be considered that one good is the principal good and the other an addition or accession to the principal good. The owner of the principal good usually became the owner of the accession. The strongest kind of accessio is accession which arises as a result of the accession of a good to land. Where a building or structure is erected on land, the building would generally accede to the land (unless it is moveable in nature) and, as a result, become the property of the land owner. As a result, leasehold improvements effected under a lease agreement by the lessee which permanently accedes to the land or buildings become the property of the land owner. The use of the improvement will only pass to the land owner or lessor on termination of the lease.
The VAT consequences of the supply of the use of the property made available by the lessor to the lessee and leasehold improvements effected by the lessee to the property of the lessor or land owner can be analysed based on the concept of accessio.
The VAT Act deems the supply of use of property in terms of a rental agreement to be a supply of goods. The VAT time of supply rule in respect of the supply of use of property is fairly straightforward. The VAT Act deems goods supplied under a rental agreement which provides for periodic payments to be successively supplied for successive parts of the period of agreement and each successive supply is deemed to take place when the payment becomes due or is received, whichever is the earlier.
The VAT value of supply rule applicable to the supply of use of property can be trickier. The general VAT value rule deems the value of the supply of the use of property to be the amount of consideration paid for the use of the property. The term “consideration” (which includes VAT) includes payment made or to be made, in money or otherwise, or any act or forbearance, whether voluntary or not, in respect of, in response to, or for the inducement of a supply.
The VAT Act further determines that the value of the consideration shall be the amount of money (lease premiums) to the extent that the consideration is consideration in money; and the open market value of the consideration to the extent that the consideration is not in money. Where the lessor and lessee agree open market value lease premiums without any other obligations arising for the lessee, the value of the consideration would be the lease premiums. Where the lessor and lessee agree that, in addition to the lease premiums, the lessee undertakes to effect leasehold improvements, the consideration for the use of property changes from a straight forward “consideration in money” scenario to a situation which includes part “consideration in money” (that is the lease premiums agreed) and part “not consideration in money” (that is the leasehold improvements).
The lessor receives lease premiums and leasehold improvements in exchange for the supply of the use of the property (a typical barter transaction). The lessor then needs to determine (presumably by valuation) the open market value of the leasehold improvements which, together with the lease premiums, constitute the consideration for the supply of the use of the property provided by the lessor to the lessee.
As the leasehold improvements will usually only pass to the land owner or lessor on termination of the lease this diminishing effect on the open market value of the leasehold improvements in the hands of the lessor would need to be taken into account in determining the value of this component of the consideration. Where it can be demonstrated that the value of the leasehold improvements would, in effect, be reduced to nil or consumed in full by the lessee over the duration of the lease, it is arguable that no value should be attached to this component of the consideration. The combined consideration sum is then the value for VAT purposes.
The VAT value of supply rule applicable to “connected persons” (as defined) provides that where (i) a supply is made for no consideration or for a consideration which is less than the open market value; (ii) the supplier and recipient are connected persons; and (iii) if a consideration equal to the open market value had been paid by the recipient, he would not have been entitled to a full input tax deduction, the consideration in money for the supply is deemed to be the open market value of the supply.
Leasehold improvements effected by a lessee on the land or property of a lessor constitute a supply for VAT purposes from the lessee to the lessor.
The general VAT time of supply rule determines that the time of supply is the earlier of the time that an invoice is issued or when payment of consideration is received by the recipient. Generally, the VAT time of supply will not be triggered if no invoice has been issued and no payment is made for the leasehold improvements, irrespective of whether an obligation exists to effect the improvements. The lessee will then not be obliged to account for output tax and the lessor will not be entitled to an input tax deduction in respect of the improvements. However, as the term “consideration” includes “any act or forbearance” in respect of, in response to, or for the inducement of a supply, a reduction in lease premiums agreed by the lessor in lieu of leasehold improvements to be effected could arguably constitute payment of consideration and trigger the VAT time of supply. Alternatively, the lease agreement could determine or imply that the leasehold improvements to be effected results in or effects reduced lease premiums payable and could constitute “a document notifying an obligation to make payment”, which could trigger the VAT time of supply. The actual payment of consideration by the lessor to the lessee as consideration for the improvements will also trigger the VAT time of supply.
The VAT value of the supply of the leasehold improvements will usually be the consideration paid by the lessor where the lessor and lessee agree the open market value consideration.
Where the lessor and lessee agree that the lessee undertakes to effect leasehold improvements, in exchange for actual payment and reduced lease premiums payable, the consideration for the leasehold improvements changes from a straight forward “consideration in money” scenario to a situation which includes part “consideration in money” (that is actual payment agreed for the improvements) and part “not consideration in money” (that is the reduced lease premiums agreed).
The lessee receives actual payment for the leasehold improvements and pays reduced lease premiums (again a typical barter transaction). The lessee then arguably needs to determine the net present value of the reduction in lease premiums which, together with the actual payment received for effecting the leasehold improvements, constitute the consideration for the supply of the leasehold improvements by the lessee to the lessor. Where the lessee and lessor are connected persons, the connected persons’ VAT value rule will apply.
The intricacies of VAT on leasehold improvements could potentially impact the lessor and lessee and need to be carefully articulated and managed to avoid unnecessary VAT costs. Also, the very specific income tax provisions need to be managed carefully.
Ferdie Schneider is tax partner in the value-added tax division at KPMG.