Little publicity has been given to the Value Added Tax (Buildings and Land) Order 1990, and for those who have found the VAT legislation introduced in the Finance Act 1989 difficult to apply in practice, 1991 is not destined to bring much joy. Customs & Excise published the order in draft during August and invited comments by September on the basis that the new legislation would be introduced early in 1991. This legislation is still in draft and it is unclear at present whether it will be enacted in its published form and when that will take place. It is stated to be aimed at two “loopholes” but its practical implications, for both landlords and tenants, extend far more widely. The legislation is dry and technical, but surveyors and others doing landlord and tenant work are urged to read it as it has major tax planning implications.
Loopholes
The Finance Act 1989 amended the Value Added Tax Act 1983 by introducing a self-supply charge on a developer of a building or civil engineering work on the first occasion he makes an exempt supply by selling the freehold, granting a lease or occupying the building for his own exempt activities within 10 years of completing the building works. The effect of the self-supply rules is to require the developer to be treated as receiving and making a supply for VAT purposes, but restricts the amount of VAT that can be recovered on the supply made to him, resulting in an actual tax cost.
The value of the supply for the purposes of the self-supply rules is specifically set out in the legislation and requires the developer to take into account not only the value of standard-rated supplies of goods and services made in connection with the construction of the building but also the cost of the land. In the case of freehold interests this latter figure can be easily established, but with leasehold interests it is provided that future rents are to be included only if they are ascertained at the time of the self-supply. Rents charged to a developer are in practice often based on a proportion of rents which the developer is to receive from his occupational tenants, the level of which is not known until later. This legislation as originally drafted also did not include within its scope works of reconstruction, enlargement, extensions or annexes carried out to an existing building or civil engineering work. It has therefore been open to developers in appropriate cases to extend or redevelop an existing building without triggering the self-supply charge.
The order has an effect in two areas. First, the self-supply rules are amended to cover extensions, reconstructions, enlargements and annexes where the developmental lease rules do not apply. Second, in attempting to deal with the issue of valuation it introduces the concept of a “developmental lease”, thereby taking leasehold interests which fall within the new rules entirely outside the self-supply rules. The new proposals are in fact much more wide ranging in their effect which is by no means confined to the valuation issue which they have been described as addressing. It is important to realise that the concept of the developmental lease is a new creation of tax law and is unknown as such in property law. It will affect not only cases where landlord and tenant positively expect works to be undertaken but also cases where the alterations clause in a lease is very liberal (whether or not the tenant takes advantage of it).
Developmental leases
The proposals require a landlord of a developmental lease, developmental tenancy or developmental licence to charge VAT at the standard rate not only on the premium (if any) on the grant of a lease and on rental payments made pursuant to it but also on any other transaction in the land which would include, for example, a sale of the freehold reversion or even the grant of an easement.
A developmental lease is defined as a lease in respect of any land where the tenant is or has been permitted by his landlord or is otherwise entitled to:
(i) construct a building or civil engineering work; or
(ii) reconstruct, enlarge, extend or provide an annex to any existing building or civil engineering work:
(a) which is carried out wholly or partly on new building land adjoining the curtilage of the existing building; or
(b) where the total floor area of the reconstructed building (excluding any on new building land) exceeds the total floor area of the original building by not less than 20%; or
(c) where a reconstruction is carried out involving the removal of at least 80% of the floors and ceilings of the original building (whether or not they are wholly or partly replaced); or
(d) where a reconstruction, enlargement or extension of a civil engineering work is carried out wholly or partly on new land adjoining the existing work.
Where there is a standard rated supply as a result of (ii)(b) above the standard rated element is calculated by reference to the proportion of the enlarged building which is represented by the original floor area. The legislation will not apply where construction works have commenced before the date on which the legislation comes into force (this date has not yet been specified). There is no definition of “commencement” for this purpose, but a similar term was used in connection with the introduction of the self-supply rules with effect from August 1 1989. In that context, it is necessary to have commenced “meaningful” construction and this would normally be evidenced by the digging of foundations, pile driving and similar activities. The digging of a trench or other superficial activities would not be sufficient. The draft legislation gives no indication of when a refurbishment “commences”.
A leasehold interest will continue to be exempt and not standard rated where there are certain obligations which have been in existence since before June 21 1988. However, in order to benefit from this provision it is necessary for the lessee to issue a certificate to the landlord “in such form as may be specified”. The form of the required notice is yet to be published, but it is not clear whether these transitional arrangements apply if the tenant is entitled to carry out further works at a later stage. The legislation does not apply to dwellings or buildings intended for relevant residential or charitable use.
Implications
These proposals do not only apply to new leases but also expressly apply to existing leases from the time that the tenant is given permission or becomes entitled to carry out any construction or reconstruction work. Landlords should review their existing leases and licenses to see whether they have been granted on terms which will automatically require VAT to be charged on the rents and on any dealings with the landlord interest. Many tenants seek to include provisions when negotiating the terms of their leasehold interests which enable them to have as free a hand as possible when dealing with the building. Since the legislation is drafted in terms of what the tenant “has been permitted” or is “entitled” to do it is immaterial that the particular construction works are never carried out. The obligation is on the landlord to charge and account for VAT correctly where there is a standard-rated supply, and penalties and interest will be applied in the event that a lease is not recognised as developmental and VAT is not properly accounted for. It should be realised that since April 1 1990 these penalties are draconian.
The developmental lease is entirely separate conceptually from the option to tax or the self-supply rules. Unlike the self-supply rules, it will apply whether or not the lessee/developer can recover the value added tax in full. The rule appears to be “once a developmental lease, always a developmental lease”. The drafting suggests that once a tenant has held an interest in the land which he is entitled to develop any subsequent interest in the same land will be treated as a developmental lease. Accordingly, a surrender and regrant of a lease could not have the effect of creating a non-developmental lease. Similarly, varying the terms of an existing lease or granting a development licence followed by a lease which does not permit development would also fail to avoid the standard-rated supply since the documents would at one stage have permitted the tenant to develop whether or not he continues to do so.
The order also fails to specify who has to give the tenant permission to construct and there could be circumstances where a lease becomes standard-rated as a result of events of which the landlord has no knowledge. Just as it will be important for landlords to know where they are making standard-rated supplies, so it will also be necessary for tenants to appreciate that even if they do not intend to carry out building works the fact that they may be able to do so is sufficient to require them to pay VAT.
It seems, however, that the purchaser of the reversion of a developmental lease who receives the reversion by way of a taxable supply would not be a “relevant supplier” for the purposes of the proposed legislation, so that the lease will cease to be a developmental lease and rents will be standard rated only if the new landlord elects to tax. This contrasts with the rule that a tenant holding a developmental lease can never cease to be in that position so long as he has some leasehold interest in the land over which the original developmental lease was granted.
Option to tax
One of the more unsatisfactory aspects of the proposals is their uncertainty. From a landlord’s perspective, the 1989 legislation is quite clear in placing control of whether the supply of a leasehold interest (or its reversion) is standard rated firmly in his hands. This control is removed only if the landlord agrees in writing that he will not opt. Where it is necessary to look at the terms of a lease and perhaps also the surrounding circumstances to analyse whether it is developmental, the taxpayer is running a residual risk if he relies on a lease being developmental and fails to opt to tax. If the lease is not developmental in Customs’ view and a landlord has not opted to tax he could lose all the input tax accrued to the date of the Customs’ ruling because he has made an exempt supply of a lease in the interim period.
Tenants should also be aware that even if they have obtained the agreement of their landlord not to opt to tax, this will not prevent landlords charging value added tax where the lease is developmental. This is particularly unfortunate for those who suffer high levels of irrecoverable VAT. However, if a lease contains a value added tax inclusive clause and it is a developmental lease the landlord will not be able to charge VAT in addition to the rent due. Practitioners and clients alike must bear this point in mind when drafting all leases.
Self supplies
By contrast with the rules for developmental leases the application of the self-supply rules to reconstructions and enlargements seems reasonably clear. Developers will be required to make and receive a standard-rated supply for value added tax purposes when an exempt supply of a grant of an interest in land is made or the building is occupied for exempt activities within a 10-year period. Except in the case where there is an 80% reconstruction of the building there is no self supply if the enlarged building stands on land an interest in all of which has been held by the developer for the previous 10 years. There is no apportionment in the event that only part of the land has been owned for this period. It should be noted, however, that neither the 10-year rule nor the de minimis limit of £100,000 which applies for the self-supply charge are relevant in relation to the rules for developmental leases.
One of the more difficult aspects of the drafting of the rules relating to enlargements is that, for both the developmental lease and the self-supply rules where new land is built on, it must adjoin “the curtilage of the existing building”. The position is unclear where an existing building is extended to adjacent land separated by, for example, a road, a railway line, a river or similar.
The introduction of the taxation of leases based on the entitlement of the tenant in the future and on what he has been permitted to do in the past introduces major complexities in an area of value added tax legislation which has already raised many issues in its application. The Customs aim of closing a loophole will be achieved only at the expense of considerable compliance difficulties and the payment of penalties by landlords who may feel justifiably aggrieved by the manner in which new legislation seeks to tax leasehold interests the terms of which may have been agreed, in some instances, many decades ago. Customs are urged to start the new year on a positive note and reconsider not only the technicalities of the drafting but also the principle of entitlement on which it is based.
Katie Kelleber is a partner with City solicitors McKenna & Co.
