The concept of rent free periods refers to an incentive provided by landlords to attract and retain business tenants, by allowing them to occupy the leased commercial space without paying any rent for an agreed duration. However, accounting for VAT on such rent-free periods can be a complex affair.
In this comprehensive guide, we unravel all the intricate details and nuances in a simple, easy-to-understand manner. Read on to equip yourself with clarity on concepts like deemed supplies, open market valuations, and other crucial aspects that impact VAT compliance.
What Exactly is a Rent Free Period?
Before diving into the VAT implications, it is important to first build a solid understanding of what constitutes a rent free period:
A rent free period, as the name suggests, allows a new tenant to occupy the leased commercial space without paying any rent for a pre-defined period of time as mutually agreed upon in the tenancy contract. This duration could range from 1 to 12 months in the UAE.
The rent-free period serves dual purposes:
- It acts as an incentive for tenants to sign longer lease terms with the landlord. This helps the landlord ensure stable, long-term tenants.
- For tenants, it provides financial relief at the start by giving them time to establish their business operations in the new commercial space before having to pay rents.
Overall, rent free periods are a tactical tool used in negotiations between landlords and business tenants willing to sign up for longer lease contracts.
VAT Accounting Rules for Rent Free Periods
Now that we have built a solid base regarding what rent free periods entail, let us look at how they are treated from a VAT perspective:
As per UAE’s VAT legislation, the grant of a rent free period is viewed as a discount provided on the supply of the commercial property by the landlord. This means that the landlord must account for VAT even during the rent-free duration, based on specific rules.
Key technical concepts:
- Open market rental value: This refers to the expected rent amount payable on the property under normal market conditions without any concessions or discounts provided.
- Deemed supply: It means a transaction is assumed to have taken place for VAT accounting purposes even though no actual supply was made. The rent-free period is considered a deemed supply.
- Subsequent adjustment: Once the tenant starts paying the actual rent after the free period ends, the landlord must make a downward adjustment in VAT returns to offset the excess VAT charged earlier.
In summary, VAT has to be paid on rent free periods based on the open market rental value despite no monies being collected during that duration.
Let us understand this better with an example…
Illustrative Example of VAT Calculation
Consider this scenario:
- A tenant signs a lease contract for 5 years to rent an office space with an annual rent of AED 60,000
- As an incentive for signing the longer 5-year term, the landlord agrees for a 3 months rent free period for the tenant
- The open market rental value of this office, without any discounts or concessions is assessed to be AED 5,000 per month
- Total annual rent = AED 60,000
- Monthly rent = Total annual rent / 12 months = AED 60,000 / 12 = AED 5,000
Here is how the VAT will be calculated:
VAT on open market rental value for the 3 month rent free period:
- Rent for 3 months based on open market value = 5,000 x 3 = AED 15,000
- 15% VAT applicable on AED 15,000 = AED 2,250
What happens when actual rent payment resumes?
This adjustment is to offset the excess VAT which was already paid earlier based on the deemed supply value during the free term.
- The landlord had assumed a rent supply of AED 15,000 and paid VAT on it earlier
- But the actual rent supply value is only AED 5,000 per month or AED 15,000 for 3 months
Why is this adjustment important?
This adjustment ensures that at the end, the VAT calculation is accurate based on true rental income after factoring the rent free concession.
If there is no downward adjustment, it would result in excess input VAT to the landlord which was based on assumed rental income rather than actual income.
Treatment for rent free residential premises
It is important to note that VAT accounting does not apply if the rented property is used solely for residential purposes rather than commercial activity. But properties used for both commercial and residential usage (mixed-use) will still attract VAT.
Conclusion
Accounting for VAT on rent-free periods can be complex due to concepts like deemed supplies and open market valuations. This guide covered the key VAT rules where rent-free periods are considered discounts, requiring VAT payments based on estimated rental values during the free term. It is important for landlords to then make adjustments once actual rents commence, to offset excess VAT charged earlier.
Proper documentation and consulting VAT experts can help businesses comply with these requirements. Adhering to the submission of adjustments in the right tax period is also crucial. Overall, understanding and applying the principles discussed here can help both landlords and tenants navigate the intricacies of VAT accounting for common rent incentives provided in commercial leases.
FAQs
The adjustment for excess VAT paid earlier during the free term can be made in the VAT return for the tax period in which rental payments resume after the rent-free duration ends.
To support VAT accounting of rent-free periods, businesses should retain lease contracts, open market rental value reports, and calculations.
No. VAT rules state that if any rent-free accommodation is provided, it gets treated as a deemed supply regardless of whether its documented in the contract.
