Capital goods are goods used in business over a period of years. While acquiring, creating, or constructing these goods/assets the businesses buy other goods or avail services on which they pay VAT. Capital goods scheme (CGS) lays down the manner in which businesses can recover VAT so paid. The scheme is applicable to partially exempt businesses. The idea behind this scheme was to curb business practices of manipulating the proportion of taxable and exempt supplies in the period of purchase in order to reclaim more input VAT.
It is a method whereby the VAT recovery is adjusted based on the taxable use. As the taxable use increases, a further amount of input tax can be claimed, and, as it decreases, the equivalent input tax already claimed needs to be repaid.
Under this scheme, the VAT is recovered as per normal input tax rules in the year in which capital good is put to use, i.e.
- Input tax is recoverable in full if the business is wholly making taxable supplies.
- No input tax is recoverable if the business is wholly making exempt supplies.
- The proportion of input tax may be claimed if the business is making both taxable and exempt supplies.
- Any capital expenditure incurred on land and building with a VAT-exclusive value of £250,000 or more and subject to VAT at standard or reduced rate shall be covered under CGS. The expenditure includes the cost of buying, civil engineering work, construction, alteration, extension, etc.
- The scheme does not apply if:
- the assets are acquired solely for resale
- money is spent on assets which are solely for resale
- assets are acquired, or money is spent on assets, which are wholly used for non-business purposes
- Purchase of computer or computer equipment with a VAT-exclusive value of £50,000 or more.
- Purchase of aircraft, ship, boat, or other vessels with a VAT exclusive value of £50,000 or more.
An adjustment period is a time over which one reviews the extent to which a capital item is used in making taxable supplies. The adjustment period comprises intervals.
- For land and building-10 intervals
- For computer and computer equipment- 5 intervals
- Aircraft, ship, boat or other vessel-5 intervals
This period of 5/10 intervals is called an adjustment period. The first interval begins from the day the asset is first put to use and ends on a day before the start of the next partial exemption tax year. The input tax is reclaimed in the normal way in the first year. The adjustment required (if any) actually begins from the second interval and needs to be carried out annually for every subsequent interval. Sounds complicated? Let us break it down in parts and understand the working of the scheme.
How does the Scheme Works?
Step 1: Capital asset covered under CGS is constructed, built, or bought.
Step 2: In the first year of use of the said capital asset, VAT is recovered on inputs partially by applying the formula = % of taxable supplies *input VAT
Step 3: In the next year, it is discovered that the % of taxable supplies with respect to exempt supplies has changed. So it is time to rework the VAT amount recovered. The VAT recovery will be adjusted for such a difference and the amount payable to HMRC or to be recovered from HMRC shall be calculated.
Let’s understand it with the help of an EXAMPLE,
A company is engaged in a partially exempted business. 60% of its supplies are taxable in the year-1. An office building is constructed and put to use in year-1.
The VAT-exclusive value of the building is £400,000.
The VAT paid = £400,000*20% = £80,000.
The input VAT of £80,000*60% = £48,000 shall be reclaimed in year-1.
(The capital asset is a building hence adjustment period comprises of 10 intervals.)
In year-2, 70% of the total supplies are taxable. Change in percentage of taxable supplies demands reworking on reclaim of input VAT. Thus CGS adjustment shall amount to (£80,000/10)*(70-60) % = £800. So £800 shall be recovered from HMRC in Year 3.
If the amount of taxable supplies in year 3 gets reduced to 40%. Then the CGS adjustment amount shall be calculated as (£80,000/10)*(40-60) % = (£1,600). Therefore, an amount of £1,600 shall be paid to HMRC in year 3.
Who is Responsible for Carrying on CGS Adjustment?
The owner of the capital asset is required to carry on CGS adjustment. The owner is any person who acquires interest in the assets or incurs VAT charged on the product or purchaser in case of transfer of a going concern or the representative member in the case of the VAT group.
In addition to records required by the VAT law, the records should include the following for the purpose of CGS:
- capital item’s description
- value of the capital item
- amount of VAT incurred on it
- the amount of input tax reclaimed on that 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/partly disposed of before the end of the adjustment period)
Generally, records need to be kept for 6 years under VAT. But in CGS some capital assets require adjustment up to 10 years. Hence, the records for such capital assets need to be kept for such a long period as they might be required to verify the amount of adjustment calculated.
No doubt, the capital goods scheme is a little bit complicated but, it is essential to understand it so that the right amount of input tax on capital assets can be claimed. It’s important to keep a track of the expenditure incurred on eligible capital assets as well as the taxability of supplies each year to manage proper CGS adjustment accordingly.