VAT in real estate transactions

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Does VAT impact the bottom line in real estate transactions?

By Erwan Loquet – BDO Luxembourg

As the principle of an increase of the Luxembourg standard VAT rate from 15% to 17% is being decided, now is certainly the right moment to examine how and to what extent this tax affects real estate transactions.

Definitely an impact if not properly managed

Even if not necessarily at the top of the agenda of stakeholders, VAT appears in one way or another in all kinds of real estate transactions, from a traditional asset deal, a share deal, or any kind of real estate restructuring to (usually) every rental contract of business premises. This might appear at first sight quite surprising when considering that the VAT legislation in Luxembourg provides for a general VAT exemption for real estate transactions, meaning that no VAT is principally due when selling or renting out a building (art. 44§1 f&g LVL).

But “the Devil is in the details” as usual in that area, and an exemption from the output (rental income, sale proceeds) has as a corollary the loss of the related input VAT (VAT incurred on construction/maintenance/development of the building). So the answer to the title of this article is relatively straightforward when applying this principle of VAT exemption: yes, definitely, VAT impacts the bottom line of a real estate project, in such a way that a landlord, an investor or a developer will have to factor in the cost of the non-recoverable VAT in their ROI calculations if their operations remain VAT exempt. This will soon represent a cost of 17% on any associated costs and investments.

The VAT legislation however provides for the possibility (art. 45 LVL and Grand-Ducal decree of 7th march 1980) to opt for the VAT to apply on real estate transactions, under certain conditions. The main (but not the only) interest in such an option lies in the possibility of recovering the VAT paid on the costs of or investments in the building. For instance, when a rental contract is subject to VAT, the registration duties normally due (0.6% of the cumulated amount of the rent installments over the length of the rental agreement) are reduced to a fixed amount of 12€.

The conditions for the option

An option for the VAT to apply is a formal process, subject to the prior approval of the tax authorities. In case of a sale (asset deal), the approval must be obtained prior to the notarial deed. For a rental contract, a VAT option can be introduced at any time in the life of the contract, even years after its entry into force (this might be the case when a landlord plans to invest heavily in a building which until this point has been rented out without VAT).

One condition for the option is that the parties must have the nature of VAT taxpayers (“assujettis”). This does not prevent private individuals who rent out an office space or a retail store from engaging in this process, because the Luxembourg VAT authorities consider that a rental activity is sufficient to confer the nature of VAT taxpayer (a VAT registration will however be necessary in such a case). The same principle applies to a real estate company that was not registered for VAT, and which at a certain point in time engages in new investments in the building. It will still be possible for that company to register for VAT, and to agree a VAT option with its tenants in order to recover the VAT incurred on those investments.

An option for VAT to apply cannot be retroactive. It takes effect on the 1st of the month following the formal agreement delivered by the VAT office in case of a rental contract.

A VAT option: for which buildings?

The VAT law provides for the possibility to opt for the VAT to apply on real estate transactions only when the building is used by the tenant or the buyer for activities that allow him to deduct, fully or predominantly, its input VAT. The main reason behind this restriction is that the VAT charged on the top of the rent installments or the sale price must not have a distorting impact on the real estate market prices. In practice, this aim is, however, not achieved as most of the contracts now include a “VAT compensation clause” to cover the economic disadvantage suffered by the landlord when an option for VAT to apply is not possible.

Due to this condition in the law, when a building is rented out to, or purchased by, e.g., a bank, an insurance company, a doctor, an hospital, a public entity or a private individual (for housing purposes), the premises will not be affected by activities that allow a VAT deduction, and an option will not be possible. To the contrary, when a building is used by a retail store, a law firm, a commercial company, an option is possible, because those professions are entitled to recover the VAT incurred in the course of their activities.

Most contracts (sale or rental contracts) now include a standard clause that covers both hypotheses, i.e. the case where an option is possible as well as the reverse situation, and an automatic adjustment of the price depending on the VAT treatment of the transaction (“VAT compensation clause”).

As the form to be filled in to opt for VAT must be signed by both parties, it implies that they both agreed on the VAT treatment of the contract. This is usually not an issue, as the tenant or the purchaser is, by definition, in a position to recover the VAT, at least partially. For tenants, a VAT option has the additional advantage that it reduces the bill of the registration duties (“droits d’enregistrement”).

And what about parking spaces?

The rent of parking spaces obeys a different logic. Either the parking is rented out together with an office building and is thus “ancillary” (same lessor/same lessee/same location), so it then follows the VAT treatment of the main lease, or the parking is rented out separately, and is then necessarily subject to VAT. Parking spaces are indeed specifically excluded from the VAT exemption of real estate transactions provided for by the law.

Avoid potential pitfalls

The complexity of the VAT treatment of real estate transactions largely exceeds the limits of this article.  As we have seen, VAT may heavily impact the economic balance of a project. It requires to be carefully handled, especially considering the potential pitfalls along the road. Over the last few years, the VAT authorities have paid a lot more attention to the correct treatment of those transactions, which has resulted in a number of VAT audits, heavy adjustments and litigations procedures. One special VAT office has even been fully dedicated to that particular economic area, with experienced and fully trained public officers. One can only recommend that any real estate investment be proof-checked by a VAT professional.

Our guest writer: Erwan Loquet – BDO Luxembourg

Erwan Loquet,  Managing Partner/Tax BDO Ewan Loquet is Managing Partner/Tax at BDO Luxembourg.
Specialized in VAT and indirect taxes, he also has extensive experience in advising the financial sector, real estate and e-commerce. He regularly assists clients in the initial structuring or restructuring of real estate transactions.

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