How The Capital Goods Scheme Works And Some Problems To Avoid

Andrew Needham looks at problems with the capital goods scheme, and how to avoid some of them.

The capital goods scheme (CGS) is a method of adjusting the amount of input tax claimed on the purchase of a capital asset in line with its taxable use over a period of time (depending on what the asset is) of either five years or ten years. The CGS is intended primarily for partly exempt businesses. The CGS applies to:

land, buildings and civil engineering works costing more than £250,000 excluding VAT;
enlargements, alterations, extensions, or annexes to buildings which increase the floor area by 10% or more, and refurbishments of existing buildings costing more than £250,000 excluding VAT;
single computers and items of computer equipment costing more than £50,000 excluding VAT; and
aircraft, ships, boats or other vessels costing more than £50,000, excluding VAT.

It should be noted that the law refers to capital items, not just goods, so that it catches standard-rated construction services which are bought in, not just finished buildings.

If you use or intend to use the asset partly for making taxable supplies and partly for making exempt or non-business supplies, you can only reclaim a proportion of the VAT by using your partial exemption method or by carrying out a business/non-business apportionment calculation. The CGS is tied into your partial exemption calculation, and the adjustment calculation is carried out in the VAT quarter following your partial exemption annual adjustment. The CGS adjustment periods are ten years for land and buildings and five years for the other items.

As the taxable use of the asset changes, the amount of VAT reclaimed is adjusted to reflect the taxable use. This can be either good or bad news for the business, as in some cases VAT has to be repaid to HMRC if the exempt/non-business use increases, or some more VAT can be reclaimed if the taxable use increases.

Partly exempt businesses

Partly exempt businesses have to adjust the VAT reclaimed on any capital items annually in line with any changes in their partial exemption calculation. Sometimes they will pay some VAT to HMRC, and sometimes they will be able to claim back some more VAT.

Example 1: Partial exemption calculation

VAT incurred on the purchase of a property is £200,000. Based on the partial exemption recovery percentage in the first year 60% of the VAT is recoverable, so in the first period the recoverable VAT would be £120,000 (£200,000 x 60% = £120,000).

In each subsequent interval, the business is then required to imagine that it has incurred all of the VAT (£200,000) again and undertake a new calculation. In this example, the building will be used entirely for taxable business purposes for the remaining nine adjustment intervals, therefore the CGS recovery percentage will be 100% in the remaining intervals. This means that the business will be able to reclaim:

(100% - 60%) x £200,000/10 = £8,000

This VAT is reclaimed at the end of each of the remaining 9 intervals under the CGS - reflecting the increased taxable business use of the building.

Interaction with direct taxes

How are these amounts treated for direct tax purposes? The original asset purchased is probably within the capital allowances computation, and would have been included at the net cost plus any irrecoverable VAT in the year of acquisition. As the asset moves through the CGS periods the amount of irrecoverable VAT changes. Therefore that must have an effect on the capital allowance computations. The detailed rules are all found in the Capital Allowances Act 2001 (at Chapter 18). Generally, these provisions say that a payment to HMRC is treated as an asset addition, and a repayment from HMRC is treated as an asset disposal and the tax adjusted accordingly.

Property trap

The danger with the CGS is that it does not just apply to businesses that are normally partly exempt; it can also catch out businesses that can usually reclaim all of their VAT.

Example 2: Sale of business premises

A manufacturing business expands and buys new commercial premises for £400,000 plus VAT of £80,000. It reclaims all the VAT in the normal way on its next VAT return, as it is using the property in its fully taxable business. After six years, the business has out-grown the premises and they sell up and move to a bigger property. As the property is more than three years old, the sale is an exempt supply and the property is sold without VAT being charged.

The business thinks nothing of this until HMRC come to visit and point out that the property is a capital item for the purposes of the CGS (a building costing more than £250,000) and its sale was within the ten year adjustment period for buildings.

As the sale was exempt from VAT, there was a deemed change of use from taxable to exempt use and 40% of the VAT originally reclaimed (£32,000) has to paid back to HMRC. This is because the remaining four years of the CGS is treated as exempt use out of the ten year adjustment period and therefore 4/10 or 40% of the VAT originally claimed has to be repaid to HMRC.

This sum will have to be paid to HMRC. plus interest and penalties, because the VAT was not accounted for correctly under the CGS at the time the property was sold.

This pitfall can also cause problems when a business decides to rent out part of its premises during the CGS adjustment period, as it will be making an exempt supply of part of the property.

This problem can be avoided by opting to tax the property when it comes to be sold. This will then create a taxable supply of the property and there will be no clawback of the VAT previously reclaimed. However, they will need to charge VAT on the sale.

Transfer of a going concern

The CGS does not cease to apply because an asset is sold in a transaction that is outside the scope of VAT because it is the transfer of a going concern. The purchaser of the business must continue the annual adjustments for the balance of the adjustment period.

This means that the purchaser must ensure that the records transferred include the necessary details of the date of acquisition, the input tax incurred at that time, and the percentage of that tax which was recovered by the vendor. It also means that the purchaser may be able to reclaim, or have to pay, some of that tax with a consequent reduction or increase in the effective cost to him of the asset. So when buying an asset, the new owner will have to take into account the potential changes in VAT recovery made by the original owner.

Practical Tip:

If you own an item that comes within the CGS, make sure you monitor any change of use and adjust the VAT reclaimed. If you are selling a property covered by the CGS, don’t forget to opt to tax it before the sale, and remember to adjust your capital allowance claim.