13 Nov 2018

Revisiting VAT for Schools

Authored by: Michael Lunjevich and Jessica Lambert

In brief:

  • Just because schools supply zero-rated/exempt services does not mean they do not have to worry about VAT
  • VAT is payable on Musataha rent for schools. Determining when this VAT arises can be complicated
  • There are some cases where schools can recover the VAT they have paid

A full year has almost passed since the introduction of VAT on 1 January 2018, and many operators and landlords are now fully comfortable with the VAT regime and its application. However, it is also clear that some businesses are still not yet fully compliant or may be operating under assumptions that aren’t entirely correct, which can have severe consequences.

The Federal Tax Authority’s (FTA) administrative penalties alone can be very severe such as fines of up to 50% of unpaid VAT, plus daily penalties and penalties per incorrectly accounted for invoice. Therefore, mistaken assumptions about VAT compliance can prove very costly.

To illustrate the complexity associated with understanding the full impact of VAT we have focused on the  highest expense for most schools: rent. Both schools and their landlords need to be careful and must not get confused between zero rating and/or the exempt status in respect of leases.

Before we explore some of the hidden pitfalls, here is a brief refresher on the three tax liability categories:

  • Taxable: taxable supplies are taxed at the applicable VAT rate (currently, this is 5%). Costs incurred in providing taxable supplies may be reclaimable;
  • Exempt: exempt supplies are not taxable; however, the VAT on costs incurred in providing exempt supplies cannot be claimed back from the FTA; and
  • Zero-rated: the supply is taxable at 0%. Costs incurred in providing taxable supplies may be reclaimable.

Key Considerations for Leases

Although some schools own freehold title to the school plots on which they operate, most schools hold leasehold or Musataha rights in respect of such plots. Some schools and their landlords make the mistake of believing that VAT is not payable on rent because the school is supplying a zero-rated service (i.e. education) or because the lease related to ‘bare’ land at the start of the lease and consequently they believe such rent is VAT exempt, which may not be correct.

So when exactly is tax payable on rent? Is it paid by the tenant or the landlord? Is it reclaimable?

The first step in answering these questions is to work out exactly what property is being leased.

Land and buildings

Where a school leases a plot together with the school buildings constructed on it, this lease will be considered a supply of a commercial building and all rent paid under the lease will be fully VAT taxable. VAT will be charged on each rent instalment payment. Schools may be eligible for a refund of some or all of this VAT from the FTA. In limited circumstances, the rent set out in older leases might be considered VAT inclusive so it is important that this is checked carefully as well.

Land Only

The position is more complicated if the plot is leased as ‘bare’ land such as through long term land lease, Musataha or Dubai Real Estate Corporation (DREC) short term leases. Essentially, one must focus on what they are leasing. Is it bare land at the start of the lease? When does this status change? Is the landlord or tenant responsible for monitoring this change?

The FTA has issued guidance on leasing land for development, and this guidance states that bare land ceases to be bare land when it is ‘covered’ by partial or completed buildings or civil works. In some instances, something as minor as a utility conduit can be enough to cause the plot to qualify as covered land. VAT liability is also triggered at certain stages of development or when certain works are installed on the plot including civil works, some services, buildings, or building foundations where they protrude above ground.

Musataha Leases

The situation is less clear where Musataha leases are concerned. The FTA guidance is stated to apply to leases of bare land for development, which one might assume is a Musataha. However, an argument can be made that a Musataha is not a lease at all, but is rather a special right in rem created under the UAE Civil Code where the Musateh (the beneficiary of the Musataha right) owns the buildings constructed on the land. Therefore, one could argue that the land owner granting the Musataha right ought not to be construed as making a taxable supply of such buildings because he has no rights over the buildings at all, and is not supplying those buildings for consideration. More guidance may be required from the FTA on Musataha arrangements.

When will VAT be chargeable on land rent?

If the land was initially bare (according to the FTA’s definition) at the start of the lease term, the rent would be exempt and would only become taxable once the plot became covered in construction (again, according to the FTA’s definition). Rent paid in advance needs to pro-rated between exempt periods and taxable periods, and VAT for the taxable period needs to be correctly accounted to the FTA.

Schools and their landlords should take care to set out in their agreements how and when the school will notify the landlord that construction has caused the plot to be covered. They also need to cater for situations where the FTA considers that the land was covered earlier than the parties determined, as penalties can be severe, as discussed above.

Can schools recover VAT?

The short answer is yes. However, as most schools also conduct other business from their premises, such as the sale of uniforms, meals, transport, and extra-curricular activities, these will need to be taken into account when assessing a school’s net VAT liability to the FTA.

Who pays?

The default position at law is that supplier is liable to account for VAT to the FTA, so in our leasing situation that would be the landlord. However, this does not mean the recipient of the good or service (i.e. the tenant in a leasing situation) has no exposure for the incorrect assessment of VAT. This is because the tenant could, by incorrect treatment, also have given an incorrect VAT return (i.e. by claiming input VAT against an exempt supply for example) so both parties must be sure their VAT treatment is correct. This makes it all the more important for the parties to have clear mechanisms for determining and agreeing on the date bare land becomes covered from a VAT perspective.

Other complexities

Rent free periods granted during construction or refurbishment periods ought also to be looked at carefully because an argument could be made that the rent free period is being offered in consideration for the construction or refurbishment completed.

Staff accommodation, should also be looked at carefully, as this would in most cases be classified as a ’residential building’ which is zero rated for the first supply but is otherwise exempt. If the supply is exempt then the costs associated with making such supply may not be claimed as input VAT.

Protect yourself

It is easy to see how schools and their landlords can fall foul of the VAT law by making simple mistakes or assumptions about the tax status of rental arrangements.

If you are involved in leasing or developing schools and would like to know more about controlling your VAT exposure or complying with VAT laws, please contact us at sectors@hadefpartners.com.