by Christopher Hedley
On June 21 the European Court of Justice held that commercial construction and civil engineering works in Britain must be subject to VAT. The changes did not stop there. That same afternoon, the Government issued a statement and a consultation paper on the subject, which also included VAT on development land, on the sale of new buildings, and on rents and certain property transactions at the landlord’s or vendor’s discretion (“the option to tax”).
The Government acted with commendable speed in reducing the uncertainty and in introducing the prospect of the option to tax. For reasons which should become clear by the end of this article, the ability of landlords to add VAT to the rent bill will dramatically reduce the impact of the European Court judgment.
The consultation period will last until August 31. The new scheme will be included within the 1989 Finance Act and will be effective from April 1 1989, although the option to tax will not be introduced until August that year.
The main problem to be resolved from the property industry’s point of view is one of definitions, with building land perhaps the greatest difficulty. Unless the Government employs a very simple definition, there will be a multitude of court cases and avoidance measures, likely to distort the property market in some way or other.
The current VAT system
To explain the effects of VAT some basic theory is necessary.
The starting point is that all goods and services are classified by Customs and Excise as “standard-rated,” “zero-rated” or “exempt” supplies. The standard rate is 15% of the value of the supply; the second and third categories do not attract any VAT.
The intention of VAT is that it is a tax on final consumers and not on economic intermediaries such as businesses. Companies supplying both zero-rated and standard-rated supplies (these are classified as “taxable”) can reclaim all the input VAT they pay: for them it largely becomes an administrative inconvenience and a cash flow problem.
The word “exempt” does not imply exclusion from VAT — it actually indicates a liability to the tax; VAT-exempt organisations cannot recover input VAT costs. Banks, pension funds, insurance companies and others in the financial sector as well as charities, private hospitals and educational establishments all make exempt supplies.
Property and VAT — now
With the exception of refurbishment schemes, VAT is currently irrelevant to most property transactions (see Table 1) either because the supply is zero-rated or because the VAT element is very small.
At present the tax is felt in the following circumstances:
- where a landlord refurbishes (VAT payable) and then lets out or sells the completed development (VAT exempt).
- agents’ and surveyors’ fees on letting and rent review where the building has not been erected by the owner (but fees tend to be small in relation to the value of the investment).
- architects’ fees on a new development for occupation by an exempt supplier unless under a design-and-build contract.
The new VAT regime
The major choice for the Government, to mitigate the impact, was between allowing landlords to charge VAT on rent and a lower rate of VAT on land and construction. They have chosen the former. Not only will rents be subject to the option to tax but so will all other property supplies which would otherwise be exempt. There is therefore the potential for all property intermediaries to reclaim input VAT associated with such supplies.
The one problem with the option to tax rents is that it is exercisable at the building level. It would be far preferable to make the choice for each tenancy.
The sale of freeholds of new buildings could be treated in a variety of ways. However, the result will probably be that new buildings sold within five years of construction will be standard-rated whereas others will be exempt with a possible option to tax.
The definition of building land is left to the discretion of member governments of the EEC. Clearly, the effects would be very different if only green field sites were to attract VAT than if any land sold with the vague possibility of future development were included in the definition, and therefore taxed at the standard rate. This is perhaps the major point still to be settled in the consultation period.
The effect of VAT on rent
Since the landlord will be able to charge VAT on the letting of a new development, he will normally exercise this right and claim back all input VAT. Most tenants will not object to this, since they will be able to recover the VAT from Customs and Excise. (They may even welcome it, since VAT paid on management charges is often passed on to the tenant in the form of a service charge and is irrecoverable. Once the rent is standard-rated this will no longer be the case.) Developers and landlords should consequently be able to recover input VAT if they can prove that the expenditure was associated with a taxable supply.
With the financial sector, however, there is no theoretical reason why tenants should pay more in rent plus VAT than they would do without; the cost in the short term should therefore fall on developers and investing institutions.
Three factors militate against this view. First, for some financial companies, rent is only a small proportion of total costs or turnover. Research on behalf of the British Property Federation indicates that for major banks the VAT element on rent might amount to only 1% of overheads after corporation tax relief. It is therefore possible to argue that such firms will shrug off the effects of VAT on rent.
Second, financial firms wanting to rent new property may pay a somewhat higher price to get the building, if the balance of supply and demand means that they have no choice but to pay the higher rent. The landlords should, of course, have been able to spot such an imbalance anyway.
Third, it could be argued that all new buildings will suffer the VAT problem as far as a bank or insurance company is concerned. Developers, knowing this, may not compete with each other to quite the same extent as they normally would in order to protect their profit margins.
What would the results be in any particular location? Rents would only come down to the extent that the market is dominated by financial sector office occupiers. In all other markets there would be no effect on the net rent receivable by the landlord.
For a location with a predominance of exempt tenants, the maximum rental or capital value reduction as a result of VAT would be 13%. (The current rental value would be split between 87% to the landlord and 13% to the taxman with VAT at 15% of rent receivable.)
The effects of imposing VAT on rent are:
- the retail and industrial sectors would remain largely unscathed. Only the office sector has a significant proportion of exempt suppliers.
- the office centres most likely to be affected are those with high proportions of exempt occupiers. These certainly include central London but also some of the other successful office centres such as Bristol, Edinburgh, Swindon, Reading etc.
- in a bullish market with a limited supply of new buildings, financial sector firms will probably bid up the rents with a fairly small effect on net rent, say, between 3% and 5%.
- in a bearish market most of the burden of VAT would fall on the landlord in the form of reduced rental income.
In so far as higher rental costs have to be paid, some exempt occupiers will take less space or move to a slightly cheaper area, or both; others may choose to pay the extra. Some secondary locations may benefit as a result. There is also likely to be a significant increase in interest in existing buildings given that rents on such properties are less likely to be taxed (see below).
Will the option be taken up?
Each developer or funding institution will be in a position to decide whether to charge VAT. Many developers feel that landlords will almost invariably opt for taxation. But we question whether this will be the case, at least in the early years of the new regime while VAT on development land is not biting.
Take an office which is to be let to an insurance company at £60 per sq ft including VAT. The tenant will be indifferent about this amount excluding VAT and a rent of £52.17 plus VAT at 15%. For the landlord there is a choice between:
- receiving £60 rent but paying 2.3% of the capital value now (see Table 2)
- paying no VAT on construction but getting only £52.17 in rent.
With the examples shown in Table 2, the City of London office has a potential VAT payment on construction and design fees of about £26 per sq ft. The VAT on rent is equivalent to about £7.85 per sq ft per year and the landlord risks losing this amount if he decides to opt for taxation. Capitalised up at its investment yield the potential effect on value is £150 per sq ft. With this scale of effect, it would be foolish not to pay the £26 of VAT on construction costs. The table shows that the landlord should pay VAT on construction even if he pays only 20% of the tax.
This same argument is valid for all three examples, although with reducing force as capital value declines. The trade-off point increases dramatically: for the Reading development, the developer or landlord would have to bear at least 46% of the extra cost before it is worthwhile paying the VAT on construction: the proportion rises to 71% for the Peterborough example.
With VAT payable on building land, developers and landlords will almost invariably exercise the option to tax. Only in the City of London is there a possibility that they will not.
Landlords of older properties with no prospect of major VAT bills in the near future would be unlikely to opt for taxation if their tenants could not reclaim VAT. However, once the option has been exercised, it cannot be varied for any future sales or lettings. Consequently, as the option is taken up with future expenditure (refurbishment or redevelopment) more and more tenancies will be standard-rated.
In summary, rents would be taxed for all retail and industrial developments and most office schemes. So long as there is no VAT on building land, the option to tax will have to be used extremely carefully on office developments where the market is chiefly composed of exempt suppliers. This will be especially important in high value areas, and particularly in the City of London. The application of VAT to development land would make the option to tax almost automatic.
The land market
As new development land is bought the effect of VAT on property and construction will be to reduce land values where there is a high representation of exempt tenants. This will enable developers’ profits to be maintained at the rate of about 15% of total costs.
The examples in Table 2 show the maximum possible reductions in land value as a result of the new VAT regime. Without VAT on building land the maximum effects on land value range between 4% in the City and 45% in the Peterborough example. It must be remembered that these figures assume that the market is dominated by firms which have to pay the VAT themselves — in most places there would be no effect at all.
With building land taxed, the effect on Peterborough is only slightly higher at 53%. Potential impact quadruples in the City of London to 19%.
In the future, developers should be willing to pay more for land where tenants are likely to be taxable — in which case VAT can be reclaimed — than for land ultimately destined to be occupied by exempt businesses. The developer’s problem is that he does not know who will occupy unless he has a very advanced prelet. Judgment will be necessary when bidding for sites: in practice, developers may build a proportion of VAT costs into their assessments of what a site is worth.
Clearly much will depend on the definition of building land which the Government adopts. If the definition excludes currently developed sites, as is possible, VAT would not generally be applied to sites in built-up areas where most exempt occupiers would choose to locate their offices. But if this is not the case, there would be a far more serious impact on land values in areas with concentrations of financial companies.
The Government has stated in its Consultation Paper that only the freehold sale of building land will be standard-rated. This leaves open the possibility of selling long leaseholds exempt from VAT as a way of avoiding the tax — a course of action which would only be necessary for developments likely to be let to exempt businesses.
Refurbishment
The introduction of VAT on new construction inevitably increases the relative attractiveness of refurbishment schemes which now, suffer 15% VAT with no ability to reclaim. Assuming that there is no option to tax rents, repairs and alterations are at least put back on to the same footing as new building projects.
With the option to tax, the developers of refurbishment schemes would be able to claim back all the input VAT if they wished to, a great improvement over the current position. The values of properties suitable for refurbishment should rise to the extent of about 15% of construction value, design costs and other fees, unless in an area with a preponderance of exempt tenants.
Owner-occupiers
Exempt owner-occupiers building for their own purposes will clearly be inhibited from investing in new facilities with 15% increases in costs. They will also be less likely to buy sites for their own offices, hospitals etc.
The wider effects
Without an option to tax, the Government estimated that the cost of VAT on construction alone on the private sector would be about £350m per year. The maximum cost with an option to tax will be £160m per year, a welcome reduction.
The various effects on individual groups have been discussed above. Each group will try its best to minimise the adverse effects with the tax being avoided wherever possible. The question remains of the wider ramifications for the property market of the new VAT regime.
With no option to tax, the bulk of the effects would have fallen on low-value areas causing developments to be delayed — or possibly cancelled. This would have been particularly serious in the North where construction accounts for a very high proportion of capital value.
The same effects will be felt, but in a much reduced way, with an option to tax. Here developments in office centres catering largely for exempt businesses will be the most affected.
With an option to tax it is to be expected that development activity will be diverted away from office areas dominated by exempt businesses.
The force of such effects will be very much influenced by wider economic considerations. If rents are shooting up at the time, the development market will probably shrug off the effects, whereas VAT would be an extra negative factor in any downturn. This might cause some in the property industry to disregard VAT but this would be a mistake. The industry as a whole has to become much more “VAT aware”: its effect will be there, whether or not it is noticed.
The introduction of VAT will inevitably cause construction activity and contracts to be squeezed into the period before the implementation date. At a time when capacity constraints are becoming daily more evident in the building industry, with burgeoning order books and with construction costs rising rapidly, contractors could be stretched even further by the extra work ordered. Problems will be especially severe in the South East with the Canary Wharf and Channel Tunnel schemes adding to all the other pressures on commercial builders. Some of the main beneficiaries will be the many subcontractors in the construction industry.
Conclusion
The Government has produced the right package to mitigate the effects of the European Court judgment. The property and construction industries should be thankful. It now remains to clarify and improve the finer details to make the new VAT regime as simple and straightforward as possible. We should be particularly concerned about the definition of building land.