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Service charges can form part of rent for VAT purposes where transactions "closely linked"

Charges for cleaning and maintenance in respect of a commercial property lease may be treated as part of the rental of that property, and therefore exempt from value added tax (VAT), where the two charges are "closely linked", the European Court of Justice (ECJ) has ruled.27 Sep 2012

Responding to a referral from a UK Tax Tribunal, the ECJ said that it was for national courts to decide, depending on the circumstances of a particular case, whether service charges and rent were "so closely linked to each other that they must be regarded as constituting a single supply" in the form of a lease.

"The fact that the lease gives the landlord the right to terminate it if the tenant fails to pay the service charges supports the view that there is a single supply, but does not necessarily constitute the decisive element for the purpose of assessing whether there is such as supply," the ECJ added in its judgment. "One the other hand, the fact that services ... could in principle be supplied by a third party does not allow the conclusion that they cannot... constitute a single supply."

The First Tier of the Tax Tribunal made the referral in August last year, after law firm Field Fisher Waterhouse (FFW) argued that the service charge on its rented London offices should be treated separately to its rent. This would allow the firm to claim back the VAT paid on the service charge, even though the rent itself is exempt from VAT. Property leases are generally treated as 'exempt supplies' for VAT purposes unless a landlord has 'opted' to charge VAT and allow business tenants to claim back the VAT they have paid.

The First Tier of the Tax Tribunal made the referral in August last year, after law firm Field Fisher Waterhouse (FFW) argued that the service charge on its rented London offices should be treated as a separate supply for VAT purposes from the rent.

If it was a separate supply, the supply of the services would be standard rated. This would allow the firm to claim back VAT on the service charge, even though in this case the rent itself was exempt from VAT and the landlord had not charged VAT on the service charge. Property leases are generally treated as 'exempt supplies' for VAT purposes unless a landlord has 'opted' to charge VAT.

The ECJ decided that cleaning services provided by a landlord to cover common areas of a property in shared occupation should be considered a separate 'supply' for VAT purposes in 2007, in a case involving Czech property management company Tellmer. However HM Revenue and Customs (HMRC) has traditionally distinguished the charges referred to by this verdict from UK service charges, which are generally levied as a condition of a lease agreement.
The service charge levied by FFW's landlord covers the repair, cleaning and decorating of exterior and common parts of the offices, as well as the maintenance of heating and air conditioning used throughout the building. Although invoiced separately, the charge is considered as part of the 'rents' on the property and the results of non-payment can include termination of the lease. FFW has claimed that the services provided are "unconnected to letting" and to a significant extent concern "the common parts of the building" rather than its own offices.

In its judgment, the ECJ said that under European law transactions are generally treated as "distinct and independent" for VAT purposes. This will not be the case where the different charges form "a single, indivisible economic supply which it would be artificial to split", or if the transaction was made up of a "principal supply" in relation to which other charges are ancillary.

Although the ultimate decision on whether the charges should be treated separately or as a single supply rested with the national court, it said, it pointed out that FFW's lease allowed it "not only to obtain the right to occupy the premises concerned, but also ... a number of services".

"It should be observed that the leasing of immovable property and the supply of associated services ... may objectively constitute [a single supply]," it went on to say. "Obtaining the services concerned cannot be regarded as constituting an end in itself for an average tenant of premises such as those at issue in the main proceedings, but constitutes rather a means of better enjoying the principal supply, namely the leasing of commercial premises."

Tax law expert John Christian of Pinsent Masons, the law firm behind Out-Law.com, said that the ECJ's decision made it likely that service charges in the UK would continue to be treated as part of the supply of a leased property.

"Although the matter has been referred back to the UK courts for decision, the guidance in the case points to service charges being part of the supply under the lease where the economic reason for the tenant entering the lease it to occupy the property with the benefit of the related services," he said. "It is likely that HMRC will provide further guidance on how they will apply the tests in practice."