Practice Note 6 Of 2007 08

[Janne Desir]

11 This Practice Note deals with the rental adjustment stage of the Revaluation process - it does not cover either of the subsequent stages of rental analysis and scheme creation. Any toning of rental evidence to the AVD should be carried out at the scheme creation stage.

1.3 From the outset, it cannot be over-emphasised how important it is to exercise skill, care and caution in the performance of this work which, if properly done should assist in the production of accurate valuations and will save many hours of effort when the assessments which are based on it come to be scrutinised on appeal.

1.6 It must be emphasised that many agreements between landlords and tenants are extremely complex and in some cases a completed Rent Return (FOR) may not cover all the facts relating to the rent. In such instances, as well as in cases where the FORs have not been fully completed, supplementary questionnaires should be sent. It is not uncommon for the details of lease agreements to be covered by confidentiality clauses. Such clauses are personal to the parties. Occupiers and owners are not however exonerated from having to comply with the legal requirement to complete a FOR.

1.7 Rents will vary greatly in their reliability and it is essential that all rents be carefully considered before identifying those, which will be relied upon to create the valuation schemes. As a general rule the more adjustment that is required, the less reliable the rent will be. It is important that low or high rents are not dismissed out of hand as unreliable without first having ensured that there is sufficient additional evidence to justify departure and prove the basis.

2.1 The objective of rental adjustment is to convert rental evidence into a form which is compatible with the definition of Rateable Value in Schedule 6 para 2(1) of the Local Government Finance Act 1988.

a) Commercial properties are normally let for a fixed term of years. The rental evidence is therefore unlikely to accord with the rating hypothesis, which assumes a tenancy from year to year with a reasonable prospect of continuance. Depending on the facts of the case, an adjustment of the rent reserved under the lease may be required (*case notes 1 and 2).

c) The contractual relationship between the actual landlord and tenant may be subject to the provisions of the Landlord and Tenant Act (LTA) 1954. This may have the effect of modifying the terms of the lease and thus the rent that might otherwise have been agreed, or it might have an effect on the future relationship.

e) Similarly, the rating hereditament is deemed to be vacant and to let without premium, but in the real world the present occupier may have paid a premium to the previous occupier or to the landlord (*case note 5).

h) Much rental evidence will derive from rent reviews determined by agreement or a third party having regard to the detailed provisions in the lease, which may be difficult to interpret or give, rise to litigation. These provisions are frequently very complex and may differ substantially from the definition of rateable value. In most cases the terms provide for upwards only reviews and in a declining market the rents determined might be in excess of the market value at the relevant date.

The objective of rental adjustment is to arrive at the virtual rent which is the true equivalent annual cost of the hereditament to the lessee. It comprises the rent which is being paid adjusted to include the net balance of the rental equivalent of any incentives received by the lessee and any expenditure incurred by the lessee by way of a premium or rateable alterations to the premises.

This guidance describes the adjustments that may be required in order to adjust a rent into a virtual rent in RV terms. It will become clear that a virtual rent may not necessarily equate to the rent at which the hereditament might reasonably be expected to let from year to year on the statutory terms. The responsibility for deciding the weight to be attached to each virtual rent rests, of necessity, within the Group, ultimately with the GVO personally. Each decision will call for the exercise of skill and care, grounded in experience and sound knowledge of the local property market.

3.1 There are no set rules governing the order of adjustment other than that the adjustment for repairs should be made last. (F W Woolworth and Co Ltd v Peck (VO) 1967 LT RA 365). However, to be consistent the following order has been adopted within the RSA application, and this Practice Note provides detailed guidance for each adjustment in similar order.

The EEC 6th Directive sought harmonisation of the VAT legislation throughout the member states on its issue in May 1977. VAT on land and buildings was introduced in the UK after a ruling given by the European Court in June 1988 that forced compliance with the 6th Directive.

Following a period of consultation the government introduced the necessary amendment to the Value Added Tax Act 1983 by means of the Finance Act 1989 which together with subsequent Statutory Instruments etc. formed the main VAT legislation, until its consolidation in the Value Added Tax Act 1994 and the Value Added Tax Regulations 1995.

To appreciate the likely effects of VAT on rent it is first necessary to have a basic understanding of the way in which the tax operates. VAT is a tax on the supply of goods and services, which may be standard-rated, zero-rated or exempt. The VAT that a business charges on the goods or services that it supplies is called output tax, and this must be passed on to Customs & Excise (C&E) by the business at the end of each accounting period. The VAT that a business pays on the goods or services that it purchases in the course of its activities is called input tax. The business will seek to recover this VAT from C&E, but the right to recover the VAT incurred on such purchases, expenses etc is dependent upon the use to which those items are put by the business, and the following provisions will apply.

Prior to 1/4/89 a combination of exemption and zero-rating operated to the effect that virtually all transactions in land and buildings did not attract a liability to VAT, whilst in most cases any input VAT incurred in new construction could be reclaimed.

From 1/8/89 the option to tax permits a business to convert an exempt supply into one, which is taxable at the standard rate, thereby enabling the owner to recover any input tax payable on an acquisition, construction or refurbishment. With minor exceptions the option applies to any exempt supply (sale or lease) of commercial land or buildings. There is now a strong incentive for landlords to elect to tax rents and it is to be anticipated that in future the majority of transactions will attract VAT, although the timing of its imposition may vary.

If, because it makes entirely VATable outputs, the tenant has full recovery of VAT on its overheads (as over 90% of all VAT registered businesses do) the VAT on the rent will generally be recoverable in the same way. The cost to such a tenant will be limited to the opportunity cost of the VAT until it is recovered from C & E. Such tenants may nevertheless welcome the imposition of VAT, as a beneficial side effect may be to change any service charge from an exempt supply to a VATable supply, thus permitting the recovery of all VAT paid on the goods and services covered therein.

However, for tenants who cannot recover all or any of the VAT on their expenditure, occupation costs will rise. The types of tenants likely to be most affected include banks, building societies, insurance companies, bookmakers, charities and small companies having a turnover below the VAT registration threshold (64,000 per annum from 1 April 2007. Such tenants are frequently referred to as VAT-averse.

Most occupiers of non-domestic property are VAT registered trading organisations, over 90% of who are immune to the more serious adverse effects of the tax. The effect of VAT on their rental bids will in general be slight. However, the rents offered by the minority of tenants who are VAT - averse may well be influenced by the increased overheads of up to 17.5% of that rent. Either such tenants might reduce their rental bid or agree a higher rental in exchange for a binding undertaking that the landlord will not elect to tax the rent.

The outcome of negotiations between individual landlords and tenants will reflect the relative strength or weakness of their respective bargaining positions. This may in turn depend on the supply of and demand for such properties. In a weak market it can be anticipated that the views of prospective tenants will hold greater sway than they might do when lettings are more plentiful. But it is essentially the balance of demand between VAT-averse and VAT-immune tenants which will determine whether there is any discernible effect on the rents agreed. Markets dominated by VAT-averse tenants, such as parts of the City of London, have the greatest potential for a duality of rental level but whether such a phenomenon does in fact exist remains to be seen.

Rent reviews and lease renewals will be determined in accordance with the terms of the lease and/or the Landlord and Tenant Acts. If the terms of the lease are specific as to the assumption regarding VAT the resulting rent can be approached with certainty. However, frequently they are not, and the rent passing on review in such cases will need to be treated with caution.

Valuers will need to exercise skill and judgement in deciding whether in any particular market some of the evidence is tainted by the uneven effects of VAT. It is thought unlikely to occur in practice but the possibility must not be overlooked

Rent inclusive of VAT should be adjusted by deducting the amount attributable to VAT. As the rent figure is gross of VAT the easiest way to do this is by dividing the gross rent by one plus the VAT rate ie if the VAT rate is 17.5% dividing the rent by 1.175.

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