Capital Goods Scheme (VAT Notice 706/2)

1. Overview

1.1 What this notice is about

This notice explains how the Capital Goods Scheme (CGS) works including which items are covered by the scheme.

1.2 Who should read this notice

You should read this notice if you acquire, create or construct capital items for use in your business and you incur VAT on those items. The aim of this scheme is to provide a fair and reasonable attribution of VAT to taxable supplies and other supplies with the right to recover VAT. Capital items can be used in your business over a period of years. Over the years the extent to which you use these in making taxable supplies can vary.

If you make, or intend to make exempt supplies, it’s important to read VAT Notice 706: partial exemption in conjunction with this notice.

1.3 How the scheme works

The scheme requires adjustments to be made to the initial amount of VAT claimed. This reflects the differences in the use of capital items over a period of time. This period is known as the ‘adjustment period’. If, during the adjustment period there’s any change in the proportion of taxable use then you must make an adjustment to your input tax to take account of this.

1.4 When the scheme does not apply

The scheme does not apply if:

• the assets are acquired solely for resale
• you spend money on assets which are solely for resale
• assets are acquired, or you spend money on assets, which are wholly used for non-business purposes

1.5 If you make only taxable supplies

You do not have to be partly exempt or have non-business activities when you incurred the costs for the CGS to apply. For example, you may use a building purchased for £600,000 plus VAT for wholly taxable purposes for 6 years. In year 7 you diversify into an exempt activity (for example, insurance) and base your new insurance team in this building. The building remains subject to the CGS and CGS adjustments may now be required.

2. Record keeping

2.1 What records you need to keep

In addition to those records shown in the VAT guide (Notice 700), your records should include the following:

• description of the capital item
• value of the capital item
• amount of VAT incurred on the capital item
• the amount of input tax reclaimed by you on the capital item
• the method used to calculate the input tax claimed on the capital item
• the start and end date of each interval, including the first
• when adjustments are due
• the date and value of disposal (if the item was disposed of or partly disposed of before the end of the adjustment period)

2.2 How long you need to keep records

You’re not required to keep VAT records for longer than 6 years. But the CGS requires you to make adjustments up to 10 years later. You should keep records long enough to show us how you calculated your initial deduction and each subsequent adjustment.

3. Scope of the CGS

3.1 Items covered by the scheme

Assets covered by the scheme are known as ‘capital items’.

The CGS applies to capital expenditure on land and buildings with a value of £600,000 or more (exclusive of VAT) which was subject to VAT at the standard or reduced rate. The purchases in question are:

• an interest supplied to an owner in land, a building or part of a building or a civil engineering work — civil engineering work should be given its everyday meaning, which includes such items as roads, bridges, golf courses, running tracks and installation of pipes for connection to mains services
• expenditure incurred in the construction of a building, part of a building or a civil engineering work
• alterations, extensions and annexes to buildings and civil engineering works
• capital expenditure on services and goods incurred in the course of refurbishing or fitting out a building that has been capitalised for accounting purposes

The CGS also applies to capital expenditure on aircraft, ships, boats and other vessels with a VAT exclusive value of £50,000 or more — as well as VAT incurred in respect of the purchase of such assets, the scheme also includes VAT incurred in the course of their manufacture, refurbishment, fitting out, alteration or extension

4. Values and definitions

4.1 What HMRC mean by ‘capital expenditure’

This is usually but not exclusively, expenditure capitalised for accounting purposes. We’ll not usually challenge your capitalisation policy for the purposes of the CGS, except in cases of avoidance or abuse.

For example, in some cases charities may incur expenditure of a capital nature on land and property which is not capitalised in their accounts (for example certain heritage buildings or churches). This is generally because the charity cannot freely exploit or dispose of the land or property concerned. This will not prevent expenditure that’s essentially capital in nature from being adjusted under the CGS.

4.2 The value of a capital item

This is the VAT exclusive value of the item.

4.3 The adjustable amount of VAT

All of the VAT incurred on an asset whether it’s mixed use VAT (VAT incurred that is used in business and non-business activities) or input tax (incurred in making taxable or exempt supplies) falls within the CGS.

4.4 Estimate the value

If you do not know if a project exceeds the value threshold for the CGS until all invoices have been received, you’ll need to estimate the value of the supplies you’ve received. This may happen with construction projects and refurbishments where VAT is incurred over a period of time and also with contracts that include a retention clause. A retention clause involves a proportion of the contract price being held back and only paid when the work has been satisfactorily completed.

If, when you start the CGS, you estimate that the value of relevant supplies will exceed the value threshold, the item will become a capital item. Even if you find later on that the value does not reach the threshold, the item remains in the scheme and you should continue to make adjustments as necessary.

If you do estimate the value of a capital item you’ll need to keep all the documents you based your estimation on, such as a contract, as our officer may ask to see it.

4.5 What you should include in the value of land or buildings that you acquire

Only include the value of the interest in the land or building supplied to you, if the supply was taxable and not zero-rated. Do not include any associated costs such as legal or estate agency fees.

In calculating the value of the interest supplied to you in the land or building, you do not need to include the value of any rent or service charges unless it’s:

• been paid or is payable more than 12 months in advance
• invoiced by the supplier for a period of more than 12 months — in that case, you should include the value of rent or service charges when calculating the value of the capital item

4.6 What you should include in the value of a constructed building or civil engineering work

You should include the total VAT exclusive cost of any of the following supplies made to you:

• the interest in the land, if the supply to you was taxable (other than zero-rated)
• taxable (other than zero-rated) goods and services supplied for, or in connection with, the construction of the building or civil engineering work

You should include all the costs involved in making the building ready, such as:

• professional and managerial services including architects, surveyors and site management
• demolition and site clearance
• building and civil engineering contractors’ services
• materials used in the construction
• security
• equipment hire
• haulage
• landscaping
• fitting out, including the value of any fixtures

4.7 If you’ve purchased land and constructed a building on it

If you’ve purchased land and constructed a building on it, this is treated as one capital item.

4.8 What to include in the value of an alteration, extension or annex where the value of the goods and services received is £600,000 or more

You should include the total value of all taxable (other than zero-rated) goods or services supplied to you for, or in connection with, the alteration, extension or annex.

You should include all the costs involved in making the building or civil engineering work ready. See examples at paragraph 4.6.

4.9 What you should include in the value if a capital item is refurbished or fitted out

You should only include the value of capital expenditure on the taxable (other than zero-rated) supply of services and of goods received in connection with either the:

• building or civil engineering work supplied to you
• refurbishment or fit out

You should include all the costs involved in making the refurbished or fitted out building ready. See examples at paragraph 4.6.

4.10 Goods to be included when calculating the value of a capital item

These are goods which become part of the fabric of the building. Generally these are items that are sold with the property and are not portable or easily removed.

‘Goods affixed’ does not include items secured for safety or security reasons or computers or computer equipment. These may be subject to the CGS in their own right.

The following lists will help you to decide if an item should be included in the value.

This list is not exhaustive and the deciding factors are usually if the item becomes part of the fabric of the building and the cost has been capitalised as part of the accounting process.

Common inclusions are:

• building materials
• internal and external walls
• roofs and ceilings
• floors and hard flooring
• permanent partitioning
• windows
• lifts
• ‘built in’ storage such as cupboards or shelving
• air conditioning
• lighting
• decorative features

Common exclusions are:

• office furniture
• storage unless it’s ‘built in’
• carpets
• computers and computer equipment

4.11 If the refurbishment is in phases

If you do this you’ll need to decide if the work should be treated as a whole for CGS purposes or if there’s more than one refurbishment. If you think that each phase is really a separate refurbishment and each meets the value threshold then they should be treated separately for CGS purposes.

Usually there’s more than one refurbishment when either:

• there are separate contracts for each phase of the work
• a contract where each phase is a separate option which can be selected, and each phase of work is completed before work on the next phase starts

A refurbishment which is only undertaken in phases because the building is occupied and where the contractors work on one floor at a time is usually considered to be only one refurbishment.

4.12 Regular refurbishments

These are sometimes referred to as ‘rolling refurbishments’.

Problems may occur if successive refurbishments begin before each adjustment period has expired. If this happens you should either:

• treat the original refurbishment as ‘destroyed’ (see paragraph 9.8) if there is nothing left of the earlier refurbishment or this earlier work is stripped out or replaced — the effect of this is that no further adjustments would be required to the input tax on the previous refurbishment
• continue to make adjustments for the remainder of the adjustment period if elements of the earlier refurbishment are retained

5. Option to hold all or part of an asset outside the VAT system

5.1 What this option is

You may make a choice, when acquiring an asset, to exclude all or part of it from your business’s assets, by holding it privately or as a non-business asset. If such an option is made, the excluded element never forms part of your business assets. The option is only available if you have private or non-business activities.

If all or part of an asset is excluded from your business assets because you hold it for private or non-business use, the costs and related VAT are also excluded from the VAT system. Expenditure relating to the element that’s been excluded from your business does not count towards the CGS threshold, but the related VAT is always non-deductible and will not benefit from adjustment if taxable use increases.

5.2 When and how the option is made

The choice to exclude any part of an asset from your business’s assets must be made at the time when the relevant expenditure is incurred and should be recorded to avoid the risk of future disputes. Evidence might include minutes of a board meeting, a note in your VAT file or similar material made at the time to evidence your decision.

5.3 How an option to hold part of an asset outside the business interacts with the CGS

The CGS will only apply to that part of the asset that forms part of your business assets and you’ll need to take into account the business or non-business use and taxable or exempt use of that part in the CGS adjustment period, as described in section 6.

5.4 CGS rules and expenditure initially allocated entirely to non-business activities

VAT on costs allocated entirely to non-business purposes is not eligible for adjustment under the CGS rules.

6. Intervals and the adjustment period

6.1 The adjustment period

An adjustment period is the time over which you review the extent to which the VAT incurred on a capital item is used in making taxable supplies.

6.2 The adjustment periods

These are:

• 5 intervals for ships and aircraft
• 10 intervals for all other capital items

6.3 Aligning the period of adjustment with your interest in an asset

Where the number of intervals comprising the usual period of adjustment (5 or 10 intervals) exceeds the number of complete years that you have an interest in the asset by more than 1, the period of adjustment is reduced to a number of intervals equal to the number of complete years plus 1, down to a minimum of 3 intervals.

The period of adjustment is reduced to the number of whole years plus 1 to cater for any residual interest (in this instance any remaining interest after whole years have been taken into account) in the capital item to help make sure there is a fair recovery of VAT.

Example — a business acquires a 7 year interest in a building that falls within the CGS

The usual period of adjustment for a building is 10 intervals. However, the business only has a 7 year interest in the asset. As 10 exceeds 7 by more than 1, the period of adjustment for the building is reduced to the number of complete years plus 1 (8 intervals).

If your interest in an asset is for fewer than 3 intervals then the asset does not fall within the CGS. This is because the CGS only deals with capital expenditure, which is generally expenditure that will be used by a business for a minimum of 2 years and this usually equates to 3 intervals under the CGS.

6.4 The first interval

For capital items the first interval is a period of time that starts with first use of the asset. This is a common start date for all categories of capital items.

First use will correspond with the first time that a capital item or part of such asset is used for business or non-business purposes. In the case of a building, this would usually correspond with:

• the earlier of the granting of a lease or licence or physical occupation
• the purchase, importation or acquisition
• when the owner first uses the item where the item is constructed, altered, extended, refurbished or fitted out
• registration (or inclusion into an existing VAT group), where the owner is not a registered person when they first use the item

The only pre-condition is that first use can only start when VAT has been incurred on the asset.

6.5 End of first interval

The first interval ends on the day before the start of your next partial exemption tax year.

If there is no change of use between the first and the second interval and the length of the 2 intervals combined is less than 12 months, the 2 intervals are rolled together and treated as the first interval.

You do not need to make any adjustment after the end of the first interval. Your usual partial exemption (or business or non-business calculation if applicable) will determine the amount of VAT you can recover at the end of the first interval.

CGS adjustments are only made after the end of subsequent intervals.

6.6 The subsequent interval

The intervals following the first interval are called subsequent intervals and are usually in line with the partial exemption tax year.

6.7 When an adjustment is required

If, in any subsequent interval, the extent to which you use an item in making taxable supplies increases or decreases when compared to your initial use, you’ll have to make a CGS adjustment. You only make CGS adjustments to subsequent intervals. No adjustments are made after the end of the first interval.

6.8 When the adjustment period ends

If you continue to use a capital item in your business for the whole of the adjustment period, the period will usually end after the fifth or the 10th interval as explained in paragraph 6.2 and paragraph 6.3. You should make your adjustment for the final interval in the usual way (see section 8) on the return for the second prescribed accounting period after the end of the interval and from then on no further adjustments are needed.

6.9 Changes in use after the final interval

You do not need to make any further adjustments for changes in use after the final interval.

7. Work out the adjustments

7.1 Work out how much input tax you can initially reclaim

You can initially reclaim VAT that’s used or to be used to make taxable supplies.

This means if the asset is used exclusively in:

• making taxable supplies, all of the input tax is deductible
• making exempt supplies, none of the input tax is deductible
• non-business activities, none of the VAT incurred is deductible

If the asset is used for a combination of non-business activities and the making of taxable and or exempt supplies, you must determine the extent of taxable use and how much VAT you can reclaim using the following steps:

1. Establish how much VAT has been incurred on the item. See section 4 about what goods and or services should be included in the value of the capital item.

2. Determine VAT incurred on business activities. If you have non-business activities you must conduct a business or non-business (BNB) apportionment calculation using a fair and reasonable methodology to determine how much VAT incurred relates to your business activities. You must keep a record of the method used to support your calculation and it must be completed before step 3.

3. Determine recoverable input tax in accordance with a partial exemption method.

If you do not have any non-business activity or you have completed the apportionment calculation in step 2, you must use either the turnover-based partial exemption standard method which is set out in legislation or a partial exemption special method (PESM) which must be approved by HMRC to determine your recoverable input tax.

For more information see VAT Notice 706: partial exemption.

7.2 Work out how much input tax you can initially reclaim where a ‘combined method’ or special method has been approved

If you have an approved combined special method your initial recovery will be calculated in accordance with that method. The method incorporates steps 2 and 3 in section 7.1.

If you have an approved PESM your initial recovery will be calculated in accordance with that method.

Many approved methods include a sector for capital projects exceeding a specified value threshold. The VAT incurred on an item exceeding the threshold is allocated directly to that sector and a specified apportionment calculation can be approved by HMRC. This approach allows for input tax to be reclaimed using an approved calculation before the item is brought into use. The same methodology is then used to make Capital Goods Scheme adjustments once the item has been brought into use.

Alternatively, you may have an approved method which allows you to adopt a ‘use’ based calculation to reclaim input tax on a new capital item. This provides a more flexible approach to determining the initial amount of input tax that can be reclaimed as you are not restricted to a specific calculation. You must consider your ‘use’ based calculation carefully because you cannot amend the initial reclaim of input tax on a capital project unless you can demonstrate there has been an error (see section 7.3).

You should be able to support your use based calculation with relevant data such as business plans (including plans used to secure funding), previous income information (where a new building is intended to replace an existing one) or floorspace and costings plans.

7.3 The ‘baseline’ recovery of VAT established at the end of the first interval

The baseline recovery percentage is the amount of deductible input tax on the asset expressed as a percentage of the total VAT on the asset.

7.4 Amending an incorrect initial claim for VAT in the first interval

The ‘baseline’ recovery of VAT on a capital item is the amount that’s deductible in the tax year or years that it was incurred in. This is then adjusted up or down with changes of use in subsequent intervals. If there were errors in the initial deduction then:

• they can be corrected only by adjustments to that initial deduction, not by making adjustments under the CGS that treat that initial deduction as if it had been correct
• if they’re outside the capping limits, they cannot be corrected at all

For more information on capping, see section 14 of VAT Notice 706: partial exemption.

To adjust the baseline you must demonstrate there has been an error in the calculation.

Example of a calculation that includes errors:

An insurance business builds a new 4-floor building and incurs £8 million net on the development. The VAT value is £1.6 million.

The insurance business has an approved PESM which allows a ‘use’ based calculation to be used for capital projects that are more than £5 million.

The insurance business holds detailed floorplans to support a floorspace calculation. It decided this method is best for how the building will be used.

Each floor measures 2,000 square metres. The insurance company intends to occupy the ground floor and half of the second floor. A taxable lease will be granted to a third party for the remaining 2.5 floors.

The baseline recovery calculation is 5,000 square metres (intended for taxable lease) divided by 8,000 square metres (total floorspace) then multiplied by 100 to give a percentage.

The correct baseline value is 62.5%.

The correct input tax recovery value is £1 million.

However, when carrying out the calculation, the insurance company included in error only 2 full floors as being leased to a third party.

It calculated baseline recovery with the following values:

• 4,000 square metres intended for taxable lease (the correct value is 5,000)
• 8,000 square metres (total floorspace)

This means their:

• baseline calculated was 50% (the correct value is 62.5%)
• input tax recovery value was £800,000 (the correct value is £1 million)

The insurance company was able to demonstrate that there had been an error in the calculation and the baseline could be adjusted from 50% to 62.5%.

If the periods in which the VAT on the item was incurred are in time to correct, specifically they are not capped, the initial deduction can be corrected and an additional £200,000 recovered.

Whether or not any errors in the initial deduction can actually be corrected, subsequent interval adjustments will always refer back to the corrected baseline. This may lead to situations where adjustments are due that common sense would say should not be. It should be considered however, that adjustments should not be made or allowed where they would result in the claiming of more than all, or less than none of the input tax effectively adjusted in that interval.

In the example of a calculation that includes errors, the business actually recovered 50% of the VAT incurred. If the error is discovered more than 4 years later, the business cannot recover the additional £200,000 but must still correct the baseline to 62.5% from the error in the initial reclaim.

In interval 6 the business uses the asset 80% for taxable purposes. Despite only recovering 50% of the VAT on the capital item, it is only entitled to use an adjustment percentage of plus 17.5% (80% minus 62.5%) in the interval 6 adjustment.

In interval 8 the business uses the asset 40% for taxable purposes. Despite only recovering 50% of the VAT on the capital item, it must use an adjustment percentage of minus 22.5% (40% minus 62.5%) in the interval 8 adjustment.

7.5 Measure the extent of taxable use in subsequent intervals

You’re required to review the extent to which VAT is deductible on the asset in each subsequent interval. To do this you must imagine that you’ve incurred all of the VAT on the asset again and repeat the steps in paragraph 7.1 taking account of any changes in use.

You need to review your business or non-business calculation in addition to your partial exemption calculation for the capital item in each subsequent interval and account for any required adjustment in the usual way.

In each of the subsequent intervals (between 2 and 9 depending on the individual item and when it was acquired) the extent of taxable use determined under the longer period partial exemption calculation (or business or non-business calculation if applicable) is compared with the ‘baseline’ recovery. The difference is called the ‘adjustment percentage’.

7.6 How to calculate the actual adjustment you must make

The actual input tax adjustment (if any) required in a subsequent interval is calculated by dividing the total VAT incurred on the capital item by the total number of intervals in the adjustment period (either 5 or 10). You then multiply by the adjustment percentage. The calculation is:

(Total VAT on the capital item ÷ Number of intervals in the adjustment period) × the adjustment percentage.

Example

A business makes both taxable and exempt supplies.

It refurbishes its head office over a period of 6 months in a single tax year and incurs £2 million of VAT.

It uses the partial exemption standard method to determine its initial claim for input tax on the building. 

The longer period adjustment in interval 1 provides for taxable use of 60%.

Where the period of adjustment is reduced so that it aligns with your interest in an asset (see paragraph 6.3), the denominator in the fraction used to determine CGS adjustments also needs to be reduced to make sure that all of the VAT incurred on the asset is reviewed over the period of time that you have an interest in the asset. This helps to make sure there is a fair recovery of VAT.

Example — a business acquires a 7 year interest in a building that falls within the CGS

One-eighth of total VAT on the capital item would be reviewed at the end of the subsequent 7 intervals.

7.7 How to deal with VAT incurred before the first interval

If you incur VAT before the first interval you’ll need to work out the overall initial percentage you can claim. Then use this to measure any change in taxable use in subsequent intervals.

If you’ve incurred VAT before the first interval you could, for example, work out the percentage of total input tax to which you were originally entitled, by expressing the total input tax recovered as a percentage of the total VAT incurred on the capital item.

Example — a partly exempt business incurs VAT before the first interval

A partly exempt business constructs a new headquarters building. It incurs £600,000 of VAT on the building in the tax year ending 31 March 2022.

Its partial exemption reclaimable percentage for the year is 75%. It reclaims £450,000.

In the following tax year, the year ending 31 March 2023, it incurs further VAT of £1.5 million.

Its partial exemption reclaimable percentage for the year is 80%.

It reclaims £1.2 million.

It occupies the building for use in its partly exempt business on 1 September 2022 so the first interval runs from 1 September 2022 to 31 March 2023 (the day before the start of the next tax year, which is 1 April 2023).

The business has therefore incurred some VAT before the first interval and will need to work out an overall average reclaimable percentage to calculate the baseline recovery percentage.

Total VAT incurred is £7.5 million.

VAT reclaimed is £5.7 million.

Average reclaimable percentage is 76%.

Therefore, 76% is the ‘baseline’ against which future adjustments are measured.

7.8 How to deal with VAT incurred after the first interval

This can happen with construction projects and refurbishments where the work is carried out over a period of time and also where contracts include a retention clause.

If you incur VAT in the first interval, you reclaim it using the usual rules. This is subject to adjustment from the end of the second interval. If you also incur VAT in the second interval, this will not form part of the CGS adjustment in interval 2, but will be adjusted from the third interval onwards.

There are examples in section 7.9 for dealing with these 2 amounts of input tax.

There are 2 options that you may wish to use to deal with input tax incurred on a capital item after the first interval. The 2 options are known as:

• combined adjustments
• parallel adjustments

All the figures in the combined adjustments and parallel adjustments tables are in thousands.

7.9 Example of dealing with VAT incurred after the first interval

This example considers a constructed building which was first occupied for fully business purposes by a partly exempt business on 1 August 2019.

At the first interval £8 million input tax was incurred on the capital item of which 75% was recovered using the business’ partial exemption reclaimable percentage. Additional amounts of input tax were incurred in subsequent intervals in completing the construction:

You must work out the VAT subject to adjustment in each interval by dividing the total VAT incurred on the capital item by the total number of intervals in the adjustment period (usually either 5 or 10).

The adjustment percentage is then calculated by using the following formula:

Total VAT subject to adjustment on the capital item ÷ the number of intervals in the adjustment period × this value by the adjustment percentage

The combined adjustment approach

Table 1 shows how the CGS adjustment percentage using the combined approach should be calculated.

Table 1 combined adjustments example

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Each time an additional amount of VAT is incurred (column A) the overall initial recovery percentage, the ‘baseline’ (column F), should be re-evaluated and used to measure against for future intervals.

The baseline can be calculated by determining what percentage of input tax has been reclaimed over the expired intervals, using the formula:

Cumulative input tax reclaimed (column E) ÷ cumulative VAT incurred (column B) then × 100 = CGS baseline percentage (column F)

At the end of interval 2 the business had reclaimed:

£9.6 million (column E) ÷ £12 million (column B) × 100 = 80% (column F).

This becomes the CGS baseline percentage for interval 3. The partial exemption recovery rate for interval 3 (75%) is compared to the new baseline for interval 2 (80%) and the CSG adjustment percentage is calculated:

Partial exemption recovery interval 3 minus re-evaluated baseline for interval 2 = CGS adjustment percentage:

75% − 80% = −5%

At the end of interval 3 the business had reclaimed:
£11.85 million (Column E) ÷ £15 million (Column B) × 100 = 79% (column F)

This becomes the CGS baseline percentage for interval 4. The partial exemption recovery rate for interval 4 (72%) is compared to the new baseline for interval 3 (79%) and the CGS adjustment percentage calculated:

Partial exemption recovery interval 3 minus re-evaluated baseline for interval 2 = CGS adjustment %:

72% − 79% = −7%

You should round special method percentages to 2 decimal places. If you are using the standard method you must round up to the next whole number unless you incur more than £400,000 of residual input tax each month on average in which case you must round to 2 decimal places.

Table 2 shows how the CGS adjustment is calculated over a 10 interval period. The total amount of input tax reclaimed is £13.65 million.

Table 2 interval examples

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The parallel adjustment approach

This approach involves carrying out separate, but simultaneous adjustments for the remaining intervals of the CGS adjustment period.

Tables of parallel adjustment intervals (PDF, 18.9 KB, 2 pages)

The total amount of input tax reclaimed is also £13.65 million.

Both calculations result in the same amount of input tax being recovered over the same time but the examples highlight 2 different approaches.

7.10 Changing method

Initial deduction and subsequent CGS adjustments are determined by your combined, PESM or partial exemption standard method.

If you do not think your usual partial exemption method gives a fair reflection of how your capital item will be used in making taxable supplies in subsequent intervals you can apply for an alternative CGS special method to determine this.

A CGS special method cannot be used to correct your initial deduction and in line with partial exemption guidance a CGS special method is generally only backdated to the start of the tax year in which it is proposed.

HMRC will consider any CGS special method that achieves a fair and reasonable result. You must obtain HMRC’s approval before using such an alternative method.

Example

A business constructs a new 3-floor head office and occupies it to make taxable and exempt supplies.

The business uses the partial exemption standard method to calculate its initial deduction (in interval 1) and claims 40% of the VAT it incurred on construction.

In intervals 2 to 5, CGS adjustments are made in line with the partial exemption standard method. 

In interval 6 the business decides to vacate 2 floors of the building and grants a taxable lease to a third party to occupy these floors. The business considers that the partial exemption standard method no longer reflects how the building is being used and proposes a CGS special method based on floorspace.

The floorspace calculation provides for 66% taxable use of the building and where HMRC approves use of the method, the remaining CGS adjustments will be calculated by reference to floorspace.

7.11 Choosing the method

The standard method override forms part of the partial exemption standard method and can be used to calculate the initial recovery and subsequent CGS adjustments to VAT on a capital item.

Where the standard method override is invoked, you must keep a record of the alternative method used and any supporting documentation you rely on to calculate your initial recovery and or CGS adjustments.

Where HMRC does not agree that your method provides for a fair recovery of input tax on the capital item, HMRC can insist that you use a particular method to calculate the extent of taxable use of the capital item in all intervals.

We’ll only insist on this if we are unable to reach an agreement on the method you should use.

We’ll write to you if we think you should use our method. If you do not agree with our decision you can ask for either of the following:

• a review of our decision
• an appeal to be heard by an independent tribunal

There’s more information about what you can do if you disagree with our decision.

7.12 Taking account of the partial exemption de minimis limit when calculating CGS adjustments

In any subsequent interval where the longer period calculation finds you to be de minimis any exempt business use in that period is generally ignored for CGS purposes. If, however, the standard method override (See VAT Notice 706: partial exemption) would have been triggered had all the input tax on the item been incurred in the year in question and treated as de minimis, this is not the case.

If we’ve agreed or directed you to use an alternative method for calculating the extent of taxable use of a capital item in subsequent intervals then you should not take account of the partial exemption de minimis limit unless the method specifies otherwise.

In subsequent intervals, you should not include input tax arising from adjustments under the CGS when applying the partial exemption de minimis limit.

You can find out more about the partial exemption de minimis limit in VAT Notice 706: partial exemption. If you have an agreed combined business or non-business and partial exemption method you’ll not be able to benefit from the de minimis rules.

7.13 If a capital item is not used for a while

Once the CGS has started, even if a capital item is not being used, it’s treated as being used for the purpose for which it’s made available. For example, part of a building is out of use for repair, it’s treated as still being used for the same purpose as it was used before the repairs began.

If you dispose of a capital item without ever having used it, see section 9.

8. Accounting for adjustments

8.1 The accounting period used to make the adjustment

You should enter your CGS adjustment amount in your VAT account for the second tax period after the end of the subsequent interval in question. This is the period after the one in which you make your partial exemption annual adjustment for the year (unless you’ve chosen to make your annual adjustment in the last period of your tax year — see VAT Notice 706: partial exemption). You should include the CGS adjustment amount in box 4 of your VAT Return.

For example if:

• your tax periods end on the last day of March, June, September and December, your tax year is the 12 months ending 31 March — you should make your CGS adjustment in the period ending 30 September
• you’re on monthly returns your tax year is the 12 months ending 31 March — you should make your CGS adjustment in the period ending 31 May
• you make payments on account, this will not affect the timing of your adjustment, which you should make

If your registration is cancelled, you enter the adjustment amount on your final VAT Return for the period ending on the effective date of deregistration.

8.2 Responsibility for carrying out CGS adjustments

The person responsible for accounting for an adjustment for a given interval is the person who is treated as owner at the point immediately prior to the end of that interval. The ‘owner’ of a capital item is a person who has or who acquires an interest in the item in question and will be the person who incurs the VAT charged on the capital item.

8.3 The owner of a capital item following a Transfer of a Going Concern (TOGC)

The purchaser is treated as the owner for CGS purposes and is also treated as having done everything that the seller has done in respect of the capital item.

8.4 The owner of a capital item in the case of a VAT group

The representative member is treated as the owner of the capital item for CGS purposes whilst the real owner of the asset is in the representative member’s VAT group. The representative member is also treated as having done everything that a group member has done in respect of the asset.

9. Disposal of capital items during the adjustment period

9.1 Sale of a capital item during an adjustment period

If you sell a capital item before the end of the adjustment period, your adjustment for the interval in which you sell it will be your final adjustment for that item and must include all adjustment amounts for any remaining intervals.

To work out the final adjustment:

1. For the interval in which you sell the item you should work out the adjustment amount (or in the first interval the initial reclaim of input tax) in the usual way as explained in section 7.

2. For any remaining complete intervals in the adjustment period, the capital item is treated as being used, taxable (at 100%) if the sale was a taxable supply and exempt (0%) if the sale was an exempt supply.

You should make your final disposal adjustment, including all adjustment amounts for remaining complete intervals, on your VAT Return for the second accounting period after the end of the interval in which you sold the capital item. If you have a capital item and the adjustment period ends, see paragraph 6.8.

Example

A partly exempt charity restructures its activities and decides to sell off 2 of its regional office buildings. Both buildings are capital items with an adjustment period of 10 intervals. They were bought at different times, but are both sold in the same longer period.

Building 1

Cost £3.5 million plus £700,000 VAT.

The baseline recovery rate was 17% taxable business use, based on its business or non-business and partial exemption calculations.

There is an option to tax in effect on the building.

It is sold in interval 4 of its CGS adjustment period.

The recovery rate in interval 4 is 12%.

Building 2

Cost £2.4 million plus £480,000 VAT.

The baseline recovery rate was 14% business use, based on its business or non-business and partial exemption calculations.

There is no option to tax in effect on the building.

It is sold in interval 7 of its CGS adjustment period.

The recovery rate in interval 7 is 12%.

The charity must calculate the final adjustment amount for each capital item separately.

Building 1

The taxable use of this building in interval 4 was 12%.

The baseline recovery rate was 17%. Therefore, the adjustment percentage for interval 4 is minus 5%.

The adjustment calculation for interval 4 is:

£700,000 × −5% = £3,500.00 due to HMRC.

There is an option to tax in effect on the building so its sale will be taxable. Use of the building in intervals 5 to 10 is treated as 100% taxable.

The baseline recovery rate was 17%. The adjustment percentage for intervals 5 to 10 is plus 83%.

The adjustment calculation for each of intervals 5 to 10 is:

£700,000 × 83% = £58,100.00 recoverable from HMRC.

The final CGS adjustment for Building 1 is:

Due to (from) HMRC

Interval 4

Due to HMRC £3,500.00

Intervals 5 to 10 (6 intervals)

Due from HMRC

£58,100.00 × 6 = (348,600.00)

Total recoverable from HMRC (£345,100.00).

Building 2

The taxable use of this building in interval 7 was 12%.

The baseline recovery rate was 14%. The adjustment percentage for interval 7 is minus 2%.

The adjustment calculation for interval 7 is:

£480,000 × −2% = £960.00 due to HMRC.

There is no option to tax in effect on the building, so its sale will be exempt. Use of the building in intervals 8 to 10 is treated as 100% exempt.

The baseline recovery rate was 14%. The adjustment percentage for intervals 8 to 10 is minus 14%.

The adjustment calculation for each of intervals 8, 9 and 10 is:

£480,000 × −14% = £6,720.00 due to HMRC.

The final CGS adjustment for Building 2 is:

Due to (from) HMRC

Interval 7

Due to HMRC £960.00

Intervals 8 to 10 (3 intervals)

Due to HMRC

£6,720.00 × 3 = £20,160.00

Total due to HMRC £21,120.00

Because the charity sold both buildings in the same longer period, the overall adjustment it will have to make is:

Building 1 recoverable from HMRC (£345,100.00)

Building 2 due to HMRC £21,120.00

Total recoverable from HMRC (£323,980.00)

The business will make this adjustment on its VAT Return for the second VAT period after the end of the interval in which it sold the items.

9.2 How to deal with a transfer of a going concern (TOGC)

If you dispose of a capital item as a transfer of a going concern — see VAT Notice 700/9: transfer of a business as a going concern — you’ll need to give the new owner the details of the capital item so that future CGS adjustments can be made. As a future new owner you should ask the seller for information on the capital item being sold as a TOGC which relates to the CGS ‘status’. The new owner must continue making the CGS adjustments for any remaining intervals.

The examples in paragraph 9.3 and paragraph 9.4 explain this in more detail.

9.3 Example 1 of dealing with a TOGC

A fully taxable company constructs a new business premises for £1 million plus VAT. The company recovers the input tax at 100% and uses it as intended in the business for 2 years. In the following year the company decides to let a specific area of the fourth floor. The company does not opt to tax — the supply is exempt. The company is aware of the CGS and makes an appropriate adjustment.

After a further 2 years the company decides to move the taxable operations and sells the building (the building is no longer new) with the benefit of an existing tenant to a VAT-registered property company. This supply is treated as a TOGC. (Neither party has to opt to tax in these circumstances.)

The new owner does not opt to tax and continues to let the premises to the existing and new tenants. The supplies are exempt and during the period covered by the CGS the use has changed from fully taxable to exempt.

The new owner must repay a percentage of the input tax originally claimed by the previous owner. This can be as much as one-tenth for each remaining interval.

9.4 Example 2 of dealing with a TOGC

A hotel chain incurs £3 million plus VAT on a total refurbishment of one of its prestigious hotels. It only makes taxable supplies from the hotel and recovers 100% of the tax incurred. After 5 years the hotel is sold as a TOGC to another hotel chain. Neither party has opted to tax the premises.

The new owners decide that in addition to the usual bed and breakfast, there is a market for supplying conferences and bare room hire. As they have not opted to tax the supplies are exempt — the total income from this venture representing 5% of their turnover.

As the refurbishment is still covered by the scheme the new owner is liable to repay an amount of the original input tax incurred for each of the remaining intervals that the item is used in making mixed supplies.

The timing of intervals may change on transfer of the business, depending on if the new owner of the business is also taking over the seller’s VAT registration number.

9.5 If you’re the seller or new owner of a capital item

If you’re taking over the seller’s VAT registration number then:

• the interval during which the business is transferred continues without a break
• the seller does not need to make any adjustments for that interval
• as the new owner, you are responsible for any adjustments as if you had owned the capital item for the whole of that interval and for any remaining intervals in the usual way

Example

As part of a TOGC, a company with a tax year ending on 31 May each year purchases assets which are subject to CGS adjustments. It takes over the VAT registration number of the previous owner. The previous owner has made CGS adjustments in 3 previous tax years, with the most recent one being made for the tax year ending 31 March 2011. The transfer takes place on 11 October 2011. The previous owner would not make any final CGS adjustments. The new owner would make the next required CGS adjustment for interval 4, which continues uninterrupted from 1 April 2011 until the purchaser’s tax year ends on 31 May 2012, as if they had owned the assets for the whole of that interval, and the new owner would be responsible for all remaining CGS adjustments.

If you’re not taking over the seller’s VAT registration number then:

• if you’re the owner:
  • the interval in which the seller transfers the business ends on the day before the transfer takes place
  • each subsequent interval then ends on successive anniversaries of that date irrespective of if there are any future transfers of the item
• if you’re the seller:
  • you should make any adjustment for that interval on your VAT Return for the second period after the end of your tax year in the usual way
  • if you’re cancelling your registration you should make any adjustment on your final return
  • the new owner is responsible for the next interval which runs from the date of transfer to the anniversary date and any other remaining intervals which run for 12 months from each anniversary date

Subsequent intervals applicable to the transferred item may coincide with the new owner’s partial exemption tax year. If they do not, the new owner (who has to carry out successive anniversary adjustments) will need to agree a way of calculating subsequent intervals with HMRC.

Where you transfer a business as a going concern, you do not treat any capital item included as part of the transfer as ‘sold’ for the purposes of the scheme.

Example

An insurance company transfers part of its business to a competitor on 25 September 2014. The transfer includes the office building from which it ran that part of its business. The transfer qualifies as a TOGC for VAT purposes. The office building is a capital item which was bought and first used on 1 July 2012.

The seller’s tax year ends on 30 April.

The buyer’s tax year ends on 31 March.

The key dates (highlighting the end of intervals) in the CGS adjustment period of the building are:

• 1 July 2012: the company buys and uses the new building — the CGS adjustment period begins
• 30 April 2013 — end of the company’s longer period and the first CGS interval
• 31 July 2013 (or 30 April 2013 if they make their annual adjustment early): the company will make its partial exemption annual adjustment for the longer period ending 30 April 2013 — this will set the CGS baseline
• 30 April 2014 — end of the second CGS interval — the company will have to declare the CGS adjustment on their VAT Return for period 10/14
• 25 September 2014: day of the TOGC so the end of the third CGS interval — the seller will be responsible for making the CGS adjustment for the third interval on their VAT Return for period 04/15
• 26 September 2014 to 25 September 2015: the fourth CGS interval — the new owner is responsible for making the CGS adjustment for the fourth interval and subsequent intervals — if the end of the interval does not coincide with their longer period, they will have to agree a special CGS method with HMRC
• 30 April 2015: this is the end of the second VAT period after the end of the seller’s third CGS interval — the seller will declare their final CGS adjustment on the VAT return for the period 04/15 — this is the last CGS adjustment the seller will make
• 31 March 2016: this is the end of the second VAT period after the interval in which the TOGC took place — the buyer will declare the CGS adjustment for interval 4 on their VAT Return for the period 03/16
• 25 September 2016: the anniversary of the TOGC so the end of the fifth CGS interval
• 31 March each year: the buyer will declare the CGS adjustments for all future intervals on their VAT Return for the period 03/ each year
• 25 September each year: the anniversary of the TOGC so the end of all future CGS intervals until the end of the adjustment period — which will be 25 September 2020

9.6 Cancelling your registration

If you’re cancelling your registration, you may have to account for VAT on some of your business assets on hand depending on why you’re cancelling your registration and what happened when you obtained them. If, when you cancel your registration, you have a capital item covered by the scheme which is still within its adjustment period and you find that you must account for VAT on your business assets, you’ll need to make a final adjustment.

If you’re not required to account for VAT on your business assets because the VAT on the supply would be less than the monetary limit specified in VAT Notice 700/11: cancelling your registration, you’ll still be treated as having made a supply and you’ll need to make a final adjustment. This also applies if the supply was exempt or zero-rated.

You should make your adjustment in exactly the same way as in paragraph 9.1, except that you include any adjustment for the remainder of the adjustment period on your final VAT Return.

9.7 If you sell a capital item without ever having used it

If you’ve never used the item in the course or furtherance of your business, it is not regarded as a capital item for the purposes of the scheme.

If you have a capital item, which has not been used for a while, see paragraph 7.12.

9.8 If a capital item is lost, stolen or destroyed

If a capital item is lost, stolen or destroyed you should check your records to see how much the item was used in the interval in which this occurred. Calculate the CGS adjustment as if you had used the item for the whole of that interval. This is your final adjustment for the item. You do not need to make any adjustments for remaining complete intervals in the adjustment period.

You should make your final adjustment on your VAT Return for the second accounting period after the end of the tax year in which the item was lost, stolen or destroyed.

You’ll need to keep all documents which relate to the loss or destruction in case our officers wish to see them.

10. Part disposals of CGS items

10.1 How to deal with part disposals

If you make a part disposal of an asset you’ll be required to carry out a final adjustment in relation to the VAT incurred on that part of the asset that’s sold or destroyed. If the sale is a taxable supply, that part of the VAT will be attributable to taxable supplies for each remaining complete interval. If the sale is an exempt supply, that part of the VAT will be attributable to exempt supplies for each remaining complete interval. The remaining part of the VAT on the asset that’s retained by you will continue to be subject to adjustments in the usual way.

10.2 How the amount of VAT relating to a part disposal is established

The VAT attributable to the part disposal should be calculated on a fair basis. For example, where part of a building is sold, the VAT relating to the part disposal might be determined by reference to the market value of the part of the building sold as a proportion of the total market value of the building. Alternatively, it might be determined by reference to amount of the floor space sold as a proportion of the total floor space of the building. As long as the proportion of VAT attributable to the part disposal is fair, it will not be challenged by HMRC.

Example

A business acquires a building for £3 million + £600,000 VAT and first uses it on 1 April 2021. It uses the building for exempt purposes until 31 March 2026. It then decides to sell 50% (by floor area) of the building on 30 September 2026 by way of a taxable supply for £2 million + £400,000 VAT. It retains the remaining 50% of the building and continues to use it to make exempt supplies.

When the business first acquires the building, it intends using it to make exempt supplies and so none of the £600,000 VAT on the purchase is deductible. Therefore the CGS baseline recovery percentage is nil. As use does not change during the following 4 intervals, no adjustment is due. However, in interval 6 it disposes of 50% of the building and this is considered by the business to be a fair reflection of the VAT attributable to that part disposal (£300,000).

In interval 6, which runs from 1 April 2026 to 31 March 2027, the business uses the building to make a taxable supply (the part disposal) and for exempt purposes. Therefore the total VAT on the building falls to be residual. If we assume that the partial exemption recovery percentage for this part of the business is 25%, it can recover £600,000 ÷ 10 × (25% − 0%) = £15,000 in this interval.

For the remaining 4 intervals, the VAT on the part disposal (£300,000) is treated as relating to taxable supplies. Therefore, a final adjustment of £300,000 ÷ 10 (100% − 0%) × 4 = £120,000 is due to the business.

The business is required to account for output tax of £40,000 to HMRC on the part disposal in 2026. Both the interval 6 adjustment and the final adjustment for the part of the building disposed of are claimable on the second return after the end of interval 6 (in the period ending 30 September 2027).

The business also needs to carry out adjustments in relation to the part of the capital item that it retains. Assuming it continues to be used to make exempt supplies for the remaining 4 intervals, no adjustments will be due.

10.3 How the part disposal by TOGC, loss or destruction is dealt with

In these circumstances, there is no supply for VAT purposes and so no final adjustment is made for remaining complete intervals in relation to the VAT on the part of the capital item that’s been transferred, lost or destroyed. However, adjustments are still required in relation to that part of the capital item that’s retained in accordance with the usual rules (even if related expenditure on the asset falls below the CGS threshold).

If the part disposal is by TOGC the capital item is split into 2 parts and adjustments in relation to the element transferred are continued by the transferee.

11. Other rules on disposals

If you dispose of a capital item before the end of its adjustment period we may apply the disposal test. The disposal test has been updated to deal with part disposals.

11.1 How the disposal test works

The test compares the total input tax recovered in relation to the capital item with the output tax chargeable on its disposal. The total input tax recovered is the aggregate of:

• the input tax initially recovered on the capital item
• any adjustments already made under the CGS
• any final adjustment that’s required as a result of the sale of the item

If the total input tax exceeds the output tax due on the disposal of the item then, in principle, it may be necessary to adjust the amount of input tax recovered in relation to the capital item.

11.2 When the disposal test applies

The disposal test will only apply if you sell a capital item before the end of the adjustment period. You must also have benefited from an unjustified tax advantage because of the early sale. An unjustified tax advantage is usually one arising from an avoidance scheme. The owner would look to secure an amount of input tax that would still be subject to adjustment under the CGS, were it not for the sale of the item, less any output tax due on the sale.

HMRC has the discretion to exclude certain disposals from the test and therefore from any disposal test adjustment.

For example, it will not be applied:

• where an owner disposes of an item at a loss due to market conditions (such as a general downturn in property prices)
• where the value of the item has depreciated
• where the value of the item is reduced for other legitimate reasons (such as accepting a lower price to effect a quick sale)
• where the amount of output tax on disposal is less than the total input tax claimed only due to a reduction in the VAT rate
• where the item is used only for taxable (including zero-rated) purposes throughout the adjustment period (which includes the final disposal)

11.3 The disposal test adjustment

In cases where you gain an unjustified tax advantage you’ll need to calculate the amount of tax to be adjusted. To do this you’ll have to calculate the:

• net tax advantage
• net tax advantage that’s unjustified

Some form of apportionment needs to be applied to work out how much of the net tax advantage is unjustified. This might be achieved using the ratio that the value of the final taxable sale bears to the value of both the exempt supply and the final taxable sale.

12. Movements of capital items into and out of VAT groups

12.1 Item moves with a company

When a capital item is moved with a company into or out of a VAT group, the responsibility for the capital item is transferred. This means that the new owner must continue making the CGS adjustments for any remaining intervals.

12.2 Owner of a capital item moves into a VAT group

If you’re the owner of a capital item and you move into a VAT group, the relevant interval terminates a day before the move takes place.

Each subsequent interval will end on successive anniversaries of that date, irrespective of whether there are any future movements into or out of VAT groups.

12.3 Company leaves a VAT group taking capital item bought during group membership with it

If a capital item is obtained by a company while it’s a member of a VAT group and the company moves out of the group, the relevant interval terminates on the day the move takes place. Each subsequent interval shall end on successive anniversaries of that date, again irrespective of whether there are any future movements into or out of VAT groups.

The previous owner of the capital item should make any adjustment for that interval on the VAT Return for the second period after the end of the tax year in the usual way. The new owner then becomes responsible for the next interval, which runs from the date of the transfer to the anniversary date and any other remaining intervals, which run for 12 months from each anniversary date.

Subsequent intervals applicable to the transferred item may coincide with the new owner’s partial exemption tax year. However, if they do not, the new owner (who has to carry out successive anniversary adjustments) will need to agree a way of calculating subsequent intervals with HMRC.

13. VAT incurred before registration

13.1 How the legislation works

Expenditure incurred on assets of a description falling within the CGS by an unregistered business counts towards the CGS threshold. If the threshold is met, the related VAT is brought into the CGS.

When you register for VAT, you deduct one complete interval from the period of adjustment (usually 10 years for land and buildings) for each complete year (12-month period) that’s elapsed between the date of first use of the asset (see paragraph 11.3) and the date of registration.

VAT that you incurred on the asset while you were unregistered is non-deductible and so the baseline recovery percentage for the CGS is nil.

The first interval applicable to the asset will run from the date of first use (see paragraph 11.3) to the day before the start of your first tax year (finishing at the same time as the registration period — see VAT Notice 706: partial exemption). The legislation treats this as a subsequent interval and so any taxable use of the asset during the registration period will allow you to make an adjustment in your favour. Because pre-registration use is accounted for by a (potential) decrease in the number of intervals, only use in the registration period needs to be taken into account in considering the first interval adjustment. You then need to monitor taxable use over remaining subsequent intervals, making adjustments in the usual way.

Example

A business purchased a building while it was unregistered for £250,000 and incurred VAT of £50,000 (assuming a 20% rate of VAT for simplicity). It first used the building on 1 October 2009. On 1 January 2011, it registers for VAT and its first tax year starts on 1 April 2011. It uses the building entirely for making taxable supplies after it registers for VAT.

The CGS period of adjustment for the building is 10 intervals and the baseline recovery percentage is nil. However, as 1 complete year has elapsed between first use of the building and the date the business registered for VAT, the CGS period of adjustment is reduced by 1 to 9 intervals. The first interval runs from 1 October 2009 to the day before the business’s first VAT tax year which, in this example, is 31 March 2011. As the legislation treats this interval as a subsequent interval, the business needs to establish the recovery percentage for its first interval.

As the business only makes taxable supplies in the first interval, it’s entitled to recover 100% of £50,000 ÷ 10 = £5,000 in relation to the first interval. The definition of the first interval covers all the way back from first use but this simply sets the CGS running. As exempt pre-registration use is reflected by the number of intervals being reduced (in this case from 10 to 9) that use does not need to be taken into account again in the first interval adjustment. So it’s only the use while registered that’s taken into account.

Assuming the building is used entirely for taxable purposes in subsequent intervals, the business will also be entitled to recover 100% of £50,000 ÷ 10 = £5,000 in respect of the remaining 8 intervals (as the period of adjustment has been reduced to 9 to reflect use of the asset when the business was unregistered).

13.2 Reclaim VAT on capital items under regulation 111

Pre-registration VAT incurred on Capital items can only be deducted in accordance with the CGS rules and cannot be reclaimed under regulation 111. This is to prevent duplicate claims.

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