VAT and residential developers that let before they sell

From a VAT perspective, the challenge is to ensure that VAT recovered by a developer on a residential development or conversion does not become repayable to HM Revenue & Customs (HMRC) as a consequence of a change in strategy to short-term letting. Recent HMRC guidance provides both useful clarification on when and how adjustments are to be made as well as comfort on specific VAT structuring in this situation.

The key VAT rules
In broad terms:

1. A VAT registered entity can recover VAT incurred on costs ‘used’ or ‘intended to be used’ to make taxable supplies (which includes zero-rated supplies). Where VAT is recovered on the basis of an ‘intention to use’, the VAT may become repayable to HMRC if that intention changes.

2. VAT incurred on costs used to make exempt supplies (which cover most supplies of residential property) is not recoverable. Short-term lettings of residential property are exempt supplies. A residential developer can recover VAT on its development costs if they can be attributed to a zero-rated “first grant of a major interest” of a new or newly converted residential property. Such a grant covers freehold sales and long leases of over 21 years (at least 20 years in Scotland) granted by the person who constructed or converted the residential property. A zero-rated grant of residential property allows the developer to recover VAT on its development costs and to sell or lease the dwelling without charging VAT.

3. HMRC currently focus upon the first use to which a property is put to determine whether VAT which a developer has recovered (typically in the expectation of making zero-rated supplies of the completed dwellings) can be left without adjustment or whether it needs to be repaid in whole or part. Short lets prior to a sale or the grant of a long lease have raised concerns as to whether a developer can nonetheless zero-rate a subsequent sale or long lease and also as to what consequential adjustment to VAT recovered may be required.

Short lets
Revenue & Customs Brief 44/08 and Information Sheet 07/08 (both published in September 2008) provide guidance, including worked examples, on the VAT implications of residential developers deciding to temporarily let the completed homes before selling them.

HMRC make clear that temporarily letting before sale may affect the VAT recovered on the development costs and provide what HMRC call a “simple check for de minimis” (i.e. a figure below which they will ignore exempt supplies). If a developer exceeds the “de minimis”, the developer may have to adjust its past VAT recovery and restrict its future VAT recovery (exceptionally and if the developer prefers, it may be able to do this without contacting HMRC).

As regards adjusting past VAT recovery, a developer that decides to let property short-term with a view to selling at a later date, forms an intention to make an exempt supply (the short-term let) and a zero-rated supply (the sale) at a later date. This is a changed intention from the developer’s original intention to make a single, zero-rated, supply (a sale). The developer is required to compare the amount of VAT it has recovered (on the basis of its original intention) with the amount of VAT that it would have recovered had it held the changed intention all along. The difference has to be repaid to HMRC.

As regards restricting future VAT recovery, a developer that is intending to make a short-term let and subsequently sell, may have ongoing development costs on which it is incurring VAT. The developer must therefore apply a standard (or agreed) partial exemption calculation to take into account his exempt and taxable supplies of the property.

Structuring involving connected party sales and leases
To avoid the possibility of VAT claw-back, many residential developers have undertaken the following VAT structuring:

1. Before any short lets are made, the residential developer (“DevCo”) makes the “first grant of a major interest” in the completed dwellings to a “connected person” (“XCo”). Typically, XCo is a subsidiary or sister company of DevCo who, crucially for this planning, is not a member of a VAT group with DevCo even if the relationship between the two entities would otherwise permit them to be VAT grouped.

2. XCo then rents out the properties (typically on Assured Shorthold Tenancies) until such a time as they can be sold. The rentals are VAT exempt and as such, do not entitle XCo to recover the VAT it incurs on its ongoing costs. However, the amount of irrecoverable VAT should be small.

In broad terms, the zero-rated sale (or grant of a long lease) by DevCo to XCo would remove the need for DevCo to make any adjustments to the VAT it has incurred and recovered on that development.

HMRC have confirmed (Revenue & Customs Brief 54/08) that they do not consider this arrangement to be abusive. Their rationale is that Parliament intended the construction of new dwellings to be relieved from VAT and this arrangement does not produce a result contrary to that intention.

HMRC have clarified that the arrangement would be open to challenge if the VAT recovered went beyond the VAT that would normally be recovered in relation to the supply of the new dwelling, for example VAT on costs such as repairs, maintenance or refurbishment, which is not normally deductible.

Our view
We welcome this guidance from HMRC. A change in marketing strategy should be carefully considered from a tax and property law perspective. Structuring, such as that described above, may be required to avoid VAT becoming an unexpected and substantial cost of a residential development.

Source information
Michael Cant – partner, Nabarro LLP
Siobhan Mossop – associate, Nabarro LLP