Steps residential developers need to consider to mitigate potential VAT costs

All developers will want to generate as big a return as possible from a residential development. However, the sector is currently feeling the impact of the economic climate with many developers finding it difficult to sell new dwellings at the price envisaged when the development was initially costed. Some developers may therefore turn to letting as an alternative to selling, as either a temporary measure until market conditions improve or a permanent change to managing an investment portfolio.

However, letting can have a significant impact on the developer’s VAT position. While the VAT considerations alone are unlikely to make letting uneconomical, the additional VAT costs associated with lettings can be mitigated and this may affect how the developer’s change of intentions are put into practice. This article explores what developers must consider and what steps need to be taken to mitigate potential VAT costs.

General principles

Developers will be aware that if they sell newly constructed dwellings, the first sale is zero-rated for VAT purposes. This means that any VAT incurred by the business is generally recoverable. The first sale needs to be made by the same entity that has carried out the construction and it needs to be either a freehold sale or a long-term lease in excess of 21 years (the so called “grant of a major interest”). Therefore, for most residential developers, VAT isn’t really an issue as any VAT incurred on the acquisition of land and on any professional services, such as upfront planning costs, architects, surveyor, marketing, and legal fees, etc. is reclaimable from HMRC. Furthermore, services carried out in the course of the construction of new residential property (by contractors and sub-contractors) is eligible for zero rated, so VAT is unlikely to be a major consideration when it comes to costing the development. In essence, the only irrecoverable VAT is usually on items deemed by HMRC as not ordinarily installed – such as white goods, fitted furniture, carpets and curtains, etc.

Conversely, residential landlords will know that the letting of residential property is an exempt activity for VAT purposes (with no possibility of making this taxable by opting to tax).  This means that VAT incurred in relation to the letting income is not recoverable from HMRC.  As a result, developers will want to minimise the VAT they incur on the acquisition of land and building, and on the associated professional services associated with the construction of residential property.

Developer’s change of intention

In a nutshell, selling newly constructed residential property is good for VAT but letting it has its downsides. The worst-case scenario would be a developer deciding to change his intention to sell and instead letting the property on a permanent basis. VAT would not be recoverable, and any VAT already claimed during the construction phase, when there was an initial intention to sell, would be repayable to HMRC under the “claw back” provisions. As mentioned above, this would impact the VAT on the professional services associated with the development but could also result in a significant claw back where VAT was incurred and reclaimed on the initial acquisition of land.

However, where the developer’s letting activities is a temporary measure and the intention to sell is retained for when market conditions improve, the VAT position can be significantly improved with a much lower amount of VAT being subject to claw back. This is based on HMRC’s current practice of allowing a discretionary treatment that recognises the developer’s dilemma of not being able to sell immediately.

So how does this discretionary treatment work?

The basis under which only a relatively small amount of VAT is repaid relies on the developer retaining and evidencing the intention to sell. Where this is this case, and the new residential property is actually sold at some later stage, then the claw back is based on the potential income received from letting – compared with the expected selling price of the property. So, if for example the developer decides to let the property for two years, the rent receivable during that two-year period over the expected selling price of the let property acts as the basis for apportionment of the VAT that is subject to claw back. Therefore, given the high value of the expected selling price and the rent receivable over a relatively short time frame, the percentage or irrecoverable VAT is much less than losing entitlement to all the VAT.

It’s important to remember that the claw back is due in the VAT period when the developer’s intention to let is first made (and not when the first exempt rental income is received). Therefore, the claw back adjustment is based on a forward-looking expectation and once made there is no further adjustment required unless the intention to let becomes permanent. HMRC does not stipulate what period of time is regarded as temporary letting and this could be a period of 10 years or more. However, the developer will be required to demonstrate that the long-term intention is to sell. Therefore, short-term letting agreements with break clauses, together with marketing activities holding the property out for sale at various times, would provide good evidence of the developer’s intentions. These factors should be considered carefully and be put in place from the outset when the letting decision-making process is being made. If the VAT claw back position is considered at a later stage, then it’s likely that a full claw back of VAT will already have been triggered.

Is a disclosure to HMRC required?

In general, there is no requirement to approach HMRC to obtain prior approval or confirmation of the claw back adjustment. It is sufficient to simply include the claw back in the VAT return covering the date when the intention to let is made. For smaller developments it is possible that no adjustment is required if the claw back amount (together with any other exempt input VAT) is less than the partial exemption de minimis threshold (currently £625 per month on average or £7,500 per annum).

However, any claw back adjustments must achieve a fair and reasonable result for both the developer and HMRC. Therefore, the calculations should be based on realistic expectations and be supported by information that evidences the temporary change in intention. This can be in the form of emails, or letters setting out advice, business plans and board minutes that provide information relating to when the directors took the decision to let the property as well as third-party valuation reports for the expected selling price of the property to be let including its anticipated rental value.

There are some situations where approval will need to be obtained from HMRC. This could be where there are complex calculations for larger blocks of flats with a mix of properties that have been sold and some that have been let. Approval would also be required if the developer has previously agreed a special partial exemption method with HMRC and is looking to deviate from this agreed method, or simply wants to apply an alternative method that is more fair and reasonable to both sides.

Alternative solutions

Where the VAT claw back is material, then one alternative could be to sell the properties to an associated (but non-VAT grouped) company.  This would crystalise the zero-rated sale as originally intended and thereby protecting the VAT recoverable by the developer. The associated company would then undertake the letting activities (on a temporary or even permanent basis) but this would not impact the VAT recovery of the entity that developed the property. Such tax planning is not considered avoidance by HMRC, however it’s crucial that all aspects of such transactions are considered to ensure conditions necessary for SDLT group relief are met and it doesn’t give rise to corporation tax changes for the developer – either of which could outweigh the VAT saving.

Final thoughts

VAT and property related issues can be complex. The matters discussed above add an extra dimension to this complexity by introducing the concept of intention and change of intention. The adjustments required are not exact measurements but based on an expectation of certain events with a certain level of judgement to ensure they meet HMRC’s criteria of being fair and reasonable. For larger developments the VAT at stake can often be significant and therefore, the above is only a general guide and should not be relied upon as an alternative to seeking professional advice.

Would you like to know more?

If you would like to discuss the above or how it may affect you, please get in touch with your usual Blick Rothenberg contact or Alan Pearce using the form below.