Aviva – the lasting effect

It appears that the cost-of-living crisis is starting to have an impact on service charges. This is unsurprising given the adverse effect that inflation, Brexit and the war in Ukraine are all having on costs. The cost of utilities, maintenance, insurance and staff have all increased. Coupled to this, flats are not being sold as quickly and easily as previously. One major landlord has commented that even in the most prestigious developments, tenants are starting to look more closely at their service charge bills. In the commercial context with a lack of growth and inflation, tenants are increasingly investigating their service charge costs too. Given this, it is likely that service charge disputes, both in a residential and commercial context, will escalate – and that is before the Building Safety Act 2022 is taken into account. Before considering the effect of the recent VAT case on staff costs charged through service charges, it is important to note a recent Supreme Court case. Aviva In February 2023, the Supreme Court handed down judgment in Williams and others v Aviva Investors Ground Rent GP Ltd [2023] UKSC 6; [2023] EGLR 18. This case decided how far (if at all) section 27A(6) of the Landlord and Tenant Act 1985 cut down a contractual provision in a lease that provided for the residential tenant to pay a fixed proportion of common costs “or such part as the landlord may otherwise reasonably determine”. The answer was that it did not. The provision gave the landlord two rights: the first was to trigger a reallocation of the originally agreed contribution proportions and the second was to decide what the revised apportionment should be. In both respects the landlord is contractually obliged to act reasonably. The question whether there should be a reapportionment and, if so, on what percentages, was not a question for the First-tier Tribunal within the meaning of section 27A(6) of the 1985 Act. The question for the FTT was whether the reapportionment had been reasonable, and that was a question that fell within the FTT’s jurisdiction under section 27A(1) of the 1985 Act. Although one might think that this case was limited to those types of clause, the reasoning has a more significant impact on arguments in section 27A applications before the FTT. Aviva makes clear that the review by the tribunal under section 27A of the 1985 Act is limited to the contractual or statutory legitimacy of the charges. The FTT has no power to go behind the contract itself nor to take decisions under the contract for itself. The example given by the Supreme Court was where a landlord decided to replace the roof and then recharge the tenants through a service charge. The questions whether the replacement fell within the landlord’s repairing obligation (or whether it was an improvement that did not) and whether, if it was a repair, the costs satisfied the statutory reasonableness test in section 19 of the 1985 Act would all be matters for the FTT to determine. But it would not be part of the FTT’s task to make the discretionary decision itself whether to replace the roof. If the landlord’s discretionary decision was unaffected by the statutory regime and fell within the landlord’s contractual powers under the lease, then there might be at most a jurisdiction to review it for rationality as per Braganza v BP Shipping Ltd [2015] 1 WLR 1661. Battersea Reach and St George Wharf The FTT have applied the principles of Aviva recently in Various Lessees of Battersea Reach and St George Wharf v St George South London Ltd and others (LON/00AY/LSC/2019/0338). This was the first challenge in the FTT as to the reasonableness of the managing agent employing staff on site rather than the landlord, with the consequent effect that VAT was payable on those costs and charged to the tenants as part of their service charge following the comments of Judge Robinson in Ingram v Church Commissioners for England [2015] UKUT 495 (LC); [2015] PLSCS 285: “Given that the standard rate of VAT is 20%, this could potentially give rise to significantly increased service charges. That may potentially give rise to an argument as to the reasonableness of properties being managed in this way and that the VAT thus passed on via the service charge is not reasonably incurred for the purposes of section 19 of the 1985 Act. However, the appellant has not sought to raise such an argument in this case, to do so would require evidence and depend very much on the facts of the particular case. Thus it would be wrong of me to express any view about it.” Lessees in two very large multi-storey mixed-use developments next to the River Thames argued that on-site staff should be directly employed by the landlords in a way which would not attract VAT (there is an exemption when a landlord employs the staff). Over the two developments, the VAT on the staff costs was approximately £500,000 per year. They argued that a change in employer would mean that the VAT was saved and would not cause any significant additional cost or disruption to the service provided and that it was unreasonable for landlords to refuse to do so. After nine days of factual and expert evidence, and having heard some seven experts (both in property management and VAT), the FTT (comprising the president of the FTT (Property Chamber), a judge who also sat in the FTT (Tax) and a surveyor member) found in the landlords’ favour, determining that, in deciding not to employ site staff directly and to continue with the current arrangement whereby the managing agent employed the staff, the landlord had acted reasonably. The tenants had suggested that there were different models (whereby the landlords would employ the staff as opposed to the managing agents) which could be implemented that would enable the landlords to benefit from a VAT saving on staff costs. The tenants believed that up to £500,000 per annum could be saved. Findings In a well-reasoned decision, the FTT made a number of key findings. It held that the tenants had failed to make out a prima facie case for the FTT to consider. The tenants had failed to show that these arrangements were realistically capable of being implemented and failed to make a coherent initial case as to an alternative course for the landlord to adopt and for the tribunal to consider, either at the outset of the application or at any time thereafter. Further, following Aviva, the FTT made clear that it did not regulate the process by which a landlord reaches its decisions. The criticism of the process by which the landlords had reached their decisions on how to proceed with employing staff (with the benefit of hindsight) did not engage the FTT’s jurisdiction under section 27A of the 1985 Act. They considered that it was questionable whether even the challenge to the landlords’ decision to procure the supply of site staff from the managing agent rather than employ directly properly engaged the jurisdiction, as the costs outcome (that VAT would be added) was simply governed by tax law. There was no complaint about the standard or provision of the services. Further, the alternative models for the provision of site staff put forward by the tenants were not realistically capable of being implemented on the facts. There were far too many potential obstacles. In consequence, it could not be said that it was unreasonable for the landlords to adopt the stance that they did. On the evidence, it was clear that there were many complexities to implementing an alternative model, with a real risk of future litigation resulting from any change in arrangements, including on property, taxation and employment law grounds. Those were not risks that it would be unreasonable for a landlord to seek to avoid. In tax terms, it was a “very sketchy” case. There were three categories of risk that were fatal to the tenants’ case. There was and is a real, non-trivial risk of HMRC interest in the arrangements, as an impermissible species of tax avoidance and/or abuse of rights. There was and is a real, non-trivial, risk of an HMRC challenge to the arrangements on either of those bases and the outcome of such a (hypothetical) challenge could not be reliably predicted. The FTT considered, as a matter of tax law, it could not be said with any degree of certainty that would satisfy a prudent taxpayer (or the FTT) that the intended VAT consequences would even probably follow from any rearrangement of staff employment arrangements at the developments. The FTT was wholly satisfied that the risk that HMRC might not accept the validity of either model in achieving an employment shift where VAT would no longer be payable was a real and tangible risk that it would not be unreasonable for a landlord to decline to take. Reflections In any event, the likely ongoing costs of the proposed alternative structures would have exceeded any VAT savings. In the circumstances, the VAT on staff costs included in the service charges was held to be reasonably incurred. The challenge by the tenants failed at considerable cost. This recent case shows how Aviva is, and will, have an impact on the way that the FTT decides service charge challenges. Interestingly, the FTT considered that in so far as Ingram sought to discuss or examine the meaning or effect of ESC 3.18 (the exemption of VAT for service charges on staff costs), Ingram had been decided per incuriam, and probably been wrongly decided, in light of the House of Lords’ decision in Nell Gwynn House Maintenance Fund Trustees v Commissioners of Customs and Excise [1998] PLSCS 338, which was not cited to the Upper Tribunal in Ingram. But this did not matter because any doubt had been resolved subsequently by HMRC in issuing VAT Information Sheet 07/18 dated 7 September 2018 (this may, however, be something which leaseholder action groups will raise with the Treasury, as on one view HMRC changed its approach to follow a case which was wrongly decided, with the effect of increased residential service charges on large developments). Philip Rainey KC and Carl Fain are barristers at Tanfield Chambers Photo © Tima Miroshnichenko/Pexels