Most tax practitioners know the income tax treatment of leasehold improvements well. However, the VAT treatment is less familiar. The 2026 Taxation Laws Amendment Bill (the TLAB) changes the VAT rules for leasehold improvements. The change affects lessors who are not VAT vendors, which is unusual for a VAT amendment. This article discusses the existing rules and the amendment’s effect on these lessors.
Leasehold improvements for no consideration
A lessee that improves leased property incurs the cost of the improvements, while the lessor ultimately benefits as the property’s owner. Where the lessee charges the lessor for the improvements, the normal VAT rules apply. The lessee levies output tax on the charge and deducts input tax on the costs that it incurs. Whether the lessor may deduct input tax depends on how it uses the improvements.
In most cases, however, the lessee does not charge the lessor. Section 8(29) of the Value-Added Tax Act 89 of 1991 (the VAT Act) then applies. It deems the lessee to supply the improvements in the course of its enterprise, even it receives no consideration. The lessee may therefore deduct input tax on the cost of the improvements. The deemed supply takes place on the date on which the lessee completes the improvements. Section 8(29) does not apply where the lessee uses the improvements wholly to make supplies other than taxable supplies.
The lessor’s adjustment under section 18C
The policy is to then restore the overall VAT position to what it would have been had the lessor made the improvements itself. Section 18C of the VAT Act achieves this by requiring the lessor to make an adjustment by deeming the lessor to have made a taxable supply, which attracts output tax. The adjustment applies to the extent that section 17(2) would have denied the lessor an input tax deduction or that the lessor does not use the improvements to make taxable supplies. In both these instances, the lessor would not have been entitled to deduct input tax had it made the improvements itself.
The lessor calculates the adjustment by applying the tax fraction (15/115) to the value that the parties agreed for the improvements. If the parties agreed no value, the open market value of the improvements applies. The lessor then multiplies the result by its percentage of non-taxable use. The lessee therefore deducts the input tax, and the lessor accounts for output tax to the extent that it could not have deducted that input tax itself. These rules date from 2017 and are therefore not new.
Lessors who are not VAT vendors
The existing adjustment depends on the lessor being a VAT vendor. A lessee may, however, be a vendor while its lessor is not. The lessor may be too small to register as a vendor. It may also, for example, be a school that, following the recent changes, makes only exempt supplies.
The TLAB requires such a non-vendor lessor to pay tax to restore the balance. Within 30 days after completion of the improvements, the lessor must complete the prescribed form and pay the tax to SARS. The lessor calculates the tax on the agreed value of the improvements or, if the parties agreed no value, on their open market value. The mechanism resembles a reverse charge. Because the TLAB frames it as an adjustment, it is debatable whether it is a true reverse charge. That question is, however, academic. The amendment will apply from 1 April 2027.
A non-vendor lessor could therefore incur a cash cost when its lessee improves the property. Some non-vendor lessors may not expect this cost. The lessor may, however, add the VAT to the base cost of the property. The base cost is therefore higher when the lessor later sells the property. This reflects that the VAT is an actual cost that the lessor incurs in respect of the property in the state in which the lessor sells it.
Take-home message
The VAT Act contains specific rules for leasehold improvements that a lessee makes for no consideration. The TLAB extends these rules, from 1 April 2027, to a lessor that is not a VAT vendor. Such a lessor must pay tax to SARS within 30 days after its lessee completes the improvements. This is a cash cost for the lessor and a relevant consideration when the parties draft the lease agreement. I advise lessors and lessees on the VAT treatment of leasehold improvements and on how a lease agreement can provide for this cost.
