Capital Goods Scheme made easy to understand

• The capital goods scheme seeks to adjust the level of VAT reclaimed by a business
  
• The scheme applies to a limited amount of assets that exceed a certain threshold
  
• Businesses who reclaim VAT on a capital item have a duty to monitor the use of the item and report and pay back any VAT to HMRC if necessary

You might purchase a capital asset for use in your business to make supplies using it.  If the supplies are taxable then you may have found that you were able to recover the VAT incurred on purchasing the asset.  However, as years pass, the nature of the business might change and the asset may no longer be involved in a taxable supply.  If this happens, it is very possible that the provisions of the capital goods scheme may apply.

What is the capital goods scheme?

The capital goods scheme is the process of adjusting the amount of input VAT recovered on the purchase of a capital asset to reflect the actual use of the asset over a period of time. 

Assets covered by the scheme are referred to as ‘capital items’.  The actual range of assets covered is fairly limited, and those that are covered are further limited by value thresholds.  The following indicates the kind of assets included:

The period of time for which capital assets come under the scheme is known as the ‘adjustment period’.  The normal period of adjustment is 10 years for land and buildings, and five years for anything else.  Each year represents one ‘interval’, meaning that the asset is subject to review on a yearly basis.

The aim of the scheme is to compare the use of the asset with the amount of VAT reclaimed when it was purchased.  Imagine that a shop is purchased in order to trade from.  Due to the supplies being taxable, the business recovered all the VAT incurred on purchasing the building (subject to a few exceptions shops supply good subject to VAT).  Six years later, the business decides to install a post office within the shop.  Postage is an exempt supply.  In this case, the business has reclaimed all the VAT incurred on the building on the condition that it would be producing 100% taxable supplies from said  building.  It has ceased to do this. 

Therefore, the capital goods scheme provisions are triggered and the business is now liable to pay back some of the VAT it recovered.  In HMRC’s view (which is arguably fair), the initial recovery of VAT was not reflective of the use of the building, and so the capital goods scheme rules bring it back in line with what should have been claimed.

How the calculation works

The calculation for capital goods scheme is essentially a fraction that applies to the VAT initially recovered based on the number of years that the item has satisfied making taxable supplies.  It would be easiest to demonstrate this via an example.  Imagine that a business acquires a commercial property for £500,000 plus VAT of £100,000 which, after six years, is converted to residential and let as such.  Initially, the business recovered the full amount of VAT.

Within this scenario, several things should stand out.  First, the asset is a building worth more than £250,000 and it therefore qualifies as a capital item.  The second point is that the property has changed its supply to something which is exempt from VAT after six years.  Finally, the switch to an exempt supply was done within ten years, which is the adjustment period for land and buildings.  The result is that the capital goods scheme provisions are triggered.

It can be seen that for six of the ten years, the property was engaged in taxable supplies.  The remaining four years within the adjustment period were exempt and therefore it is deemed that the initial VAT recovered is not allowable for those four years.

Therefore, 4/10 (40%) is the fraction of the VAT recovered that is not allowed.  £40,000 would then be due for repayment to HMRC.

Do not get caught out, capital goods scheme can be like a pitfall trap to the unwary.  There are a number of scenarios where a business might fall into it, and once you’re in HMRC might decide to pepper you with fines for failing to account for it properly

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