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Firstly, no VAT is chargeable on the construction services. Secondly, although VAT is paid on most other costs, the developer can recover this from HMRC provided the new property is subject to a long-lease (>25 years) or a freehold sale. The only irrecoverable VAT costs incurred are typically those paid on ‘white goods’ and certain other ‘blocked’ items such as curtain and carpets.
Similar rules apply when a developer converts a non-residential building (e.g. barn/mill) into residential dwellings, except 5% VAT is payable (but recoverable) on the conversion services.
So far so good, but what if the developer is forced to rent the properties out because of poor market conditions. Many people I have spoken to over the years (including some HMRC VAT officers) have thought that this meant that any VAT recovered on the development should have to be repaid to HMRC in full because the rentals are VAT exempt.
Not so fast.
Of course, if the developer has no intention of granting a freehold interest/long-lease, then yes, none of the VAT paid on the development will be recoverable, so any VAT recovered should be repaid to HMRC, because the only income will be VAT exempt.
However, if the developer still has the intention of granting the freehold interest or long lease, there is still an intention to make a taxable supply because the first grant of a long-lease or freehold interest will still be VAT zero-rated even if this occurs after a period of VAT exempt rents. This also applies to new dwellings created by the conversion of non-residential buildings.
Because the intention to make taxable supplies continues, it is possible to attribute some of the VAT costs to this taxable ‘intention’ and some to the short-term lets. Even though the exempt lets still need to be recognised, the underlying taxable intention also needs to be considered, and the value of the taxable supply typically dwarfs the rental values.
The principles at play here were established by the Curtis Henderson case in 1992, in which the High Court ruled that even though VAT exempt supplies had been made, a developer called Curtis Henderson still had an underlying intention to make taxable supplies, so the VAT incurred on construction costs was still attributable to the intended taxable supply, and that VAT exempt supplies made in the interim should not automatically result in a VAT restriction.
In practice, an apportionment calculation needs to be made to attribute VAT costs between actual and/or anticipated exempt and taxable income, and if the VAT costs attributable to VAT exempt lettings is sufficiently low, it may even be possible to ignore the need to make a restriction (under the VAT partial exemption de minimis rules).
This is exactly what happened recently, when we were asked to review a disclosure a business had made to HMRC to repay VAT previously claimed on a barn conversion project. Having originally thought that they would have to repay £80k VAT to HMRC because they had to rent out some of the units on short term lets to fund the rest of the project, the business wanted a second opinion.
We developed a recovery method based on anticipated future use/income and obtained HMRC’s agreement that no repayment was needed because the irrecoverable VAT was below the partial exemption de minimis level.
This is a perfect example of how one of the basic rules of VAT (intention) can impact on the VAT treatment of a transaction and how essential it is to make sure all aspects of a transaction are considered.
If you have any questions about this article or about VAT in general please get in touch.
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