I’m very pleased to confirm that my latest e-book: VAT for SME residential property developers is now available. For just £19, the book was written with new and SME residential developers in mind; whether it’s your first development or you’ve done several over the past few years. It covers new construction, conversions and renovations, as well as a wide range of other issues. Find out more and how to buy your copy here.
The book contains the important VAT rules you’ll need, explained in a practical way that focuses on the 3 main stages in any property development: what you’re creating and how the finished property will be used; when you can save VAT on contractors’ fees and how much VAT you can claim from HMRC. Unfortunately It’s never possible to explain this stuff “briefly”, but the book is designed to explain the rules in the context of typical property developments, so that you can follow the VAT issues right from the initial planning to completion.
The issue of VAT is particularly important because, under the normal VAT rules, sales of existing residential properties are VAT exempt, which normally means that the developer can’t claim VAT on related costs. This additional VAT cost increases the cost of residential conversions, particularly in comparison with new builds where the construction services and sales are normally zero-rated.
It is, however, possible to claim VAT on certain conversions, as explained in the book.* However the subject of conversions is still widely misunderstood, with even experienced developers paying too much VAT because they don’t understand the rules and/or how to apply them in practice.
*You can also find the rules in HMRC’s VAT Notice 708: Buildings and construction: http://tinyurl.com/mod94mc
VAT and non-residential conversions and claiming VAT on costs
The issue of conversions is important for two reasons: first, contractors’ services for certain conversions are liable to VAT at 5%; second, the sale of a newly converted property which create additional dwellings (and certain other residential properties) may be zero-rated. This is very important because it means that the developer can claim VAT on contractors’ fees and related costs. If the sale is exempt, then you can’t normally claim VAT on costs.
So what is a conversion, anyway?
There are different criteria for these 2 different uses of the word “conversion” – I’ve explained this in some detail in my book – see Chapters 2, 8 and 12. But the main principles are that the 5% rate applies to certain work if the result of the work is to change the number of dwellings in an existing property, while the zero-rate applies to the sale of a freehold or long lease in a “non-converted” residential, which means that you have to create additional dwellings in a non-residential property. The main principles sound very similar, but in practice the zero-rating relief is narrower than the reduced rate for conversion services. This means that even if your conversion qualifies for 5% conversion services, this DOES NOT NECESSARILY mean that the sale of the converted property is zero-rated.
And it is the second of those conversions – the zero-rated sales – that is the subject of this blog. The amounts of money involved in such conversions can be significant, with VAT bills easily running into 6 figure sums, especially if the developer has paid VAT on the purchase of commercial property. However developers sometimes think that being able to claim this VAT is a bit “too good to be true”! But it is and it’s not a scheme or a tax saving “structure” that has been devised to save VAT. The rule is valid and exists for a very good reason, as I’ve explained below.
Government incentives to encourage conversions
In 1995, the government introduced the zero-rate for the sale or long lease of dwellings which have been created by converting existing non-residential buildings; or “non-residential conversions”. This meant that developers could claim the VAT on costs, in certain cases, which put them on a similar playing field to new house builders.
In 2001, the government introduced various measures to encourage property developers to develop brown field sites, rather than eating into even more of the UK’s dwindling green field land. On the VAT side, this included a number of measures, including the introduction of the 5% reduced rate for contractor’s services of certain residential conversions and renovations, the latter in particular aimed at encouraging people to return unused dwellings to the housing stock.
The VAT 1614D mechanism
Even so, that still left the potential VAT cost of VAT on the purchase of commercial properties where the vendor had opted to tax. This would increase the initial cost of the property by 20%, with the additional burden of extra stamp duty land tax on the initial purchase. Therefore, the government introduced the VAT 1614 procedure, which enables both commercial developers and private individuals who buy a commercial property for conversion for personal use, to buy a commercial property VAT exempt.
It means that if you issue a VAT 1614D certificate to the vendor before the price for a property is legally fixed, then the vendor must sell the property VAT exempt.
Of course, this is a significant benefit for both business developers and private individuals who can’t claim VAT on their costs. Even if you’re eligible to claim VAT on costs under the DIY VAT refund scheme, the scheme DOES NOT INCLUDE VAT ON THE PURCHASE OF A PROPERTY. The VAT cost of pub conversions, barn conversions, office conversions etc reduced significantly as a result of this measure.
Implications of the VAT 1614 procedure on the property vendor
The VAT 1614 procedure is a very useful mechanism for the buyer, but what about the property vendor?
For businesses, the main implication of making exempt supplies – such as selling property – is that the vendor can’t normally claim VAT on related costs. In most cases, this would only be VAT on professional fees and other costs relating to the sale (subject to the vendor’s partial exemption method).
However, in some cases, the VAT cost could be much more significant, because of the effects of the VAT “capital goods scheme” (“CGS”). Under the CGS, property sellers making exempt sales may be required to repay some or all of the VAT paid on costs that fall within the CGS. This applies to many types of property expenditure of £250,000 or more in the preceding 10 years. This could include anything from freeholds or leaseholds to a wide range of construction services.
The CGS is a complicated scheme (see VAT Notice 706/2 http://tinyurl.com/pr5d3sy for more information about the scheme. But to put it in context, I’ve recently come across a situation where the potential VAT cost for a vendor in this situation would be approximately £150,000, because the vendor had recently paid VAT on the cost of a 150 year lease extension on the property. The purchaser wanted to buy the empty commercial building and convert it to dwellings, which would be sold as long leaseholds (99 years in this case).
The vendor would, of course, have to sell the property VAT exempt if the purchaser issued the VAT 1614, but told the purchaser that the “VAT” would be added to the sales price. A potential £900,000 purchase would increase to approximately £1,050,000. Because the additional charge is not actually VAT on the sales price, but merely to cover teh cost of the vendor’s CGS liability, the purchaser couldn’t claim any of this from HMRC.
What’s the alternative?
The purchaser’s other option was to NOT use the VAT 1614 procedure, so that the vendor sells the property as a taxable supply. In this case, the selling price would be £900,000 net plus £180,000 VAT.
Of course, this would generate some additional costs for the purchaser in addition to paying the VAT, including additional stamp duty and the cost of funding the £180,000 VAT. The developers assumed that they would have to bear the cost of the VAT – the development would still be profitable as long as the developers could reduce their costs to try and make up some of the additional VAT cost.
And this is why it helps to understand the rules about conversions…..
But in fact, because they would be selling long leaseholds in “non-residential conversions”, their sales would be zero-rated which means that they can claim the VAT on the purchase cost AND other related costs from HMRC. One of the directors had real problems believing this – in fact, to begin with, he wouldn’t believe that HMRC would repay such a large amount of VAT when there was no VAT on the sales. But, as I pointed out to him, it was no different to a house builder claiming large amounts of VAT on goods and services used in the construction of new houses or flats. If you put up a relatively modest sized 20 house development, that’s a lot of bricks and mortar and a lot of VAT to claim from HMRC.
But the whole purpose of this bit of the legislation is to give property converters the same sort of VAT benefits as for house builders. It doesn’t matter whether you’re converting a huge office block into flats, a warehouse into loft apartments or a pub into a house. The principle is the same. It’s simply a case of understanding how the rules work and ensuring that your development meets all of the criteria to qualify for zero-rated sales and HMRC must repay any properly claimed VAT.