by Robert Maas
Now that the Government has been persuaded to drop its Finance Bill proposals on close investment companies perhaps the property industry can be persuaded to take a closer look at Schedule 3 to the Bill, the legislation imposing VAT on commercial property development.
After all, the fact that the Treasury ministers needed, according to Norman Lamont’s Commons statement, to be “persuaded” that to disallow a whole range of business expenses of close companies “could place some close companies at a competitive disadvantage in comparison with non-close competitors” ought to make people question whether the VAT provisions might reflect a similar ignorance of the functioning of the property industry.
It is perhaps the last opportunity for people to draw to the attention of their MPs the problems that still remain on the VAT provisions. The 15 pages of fairly complex legislation have now completed their detailed Parliamentary scrutiny in the Finance Bill Committee, and the only chance of further amendments is if the Government can be persuaded to bring forward changes at the Report Stage of the Bill, which is likely to take place in early July. Readers can draw their own conclusions as to how thorough the scrutiny has been from the fact that the committee devoted 5 1/2 hrs to consideration of these provisions, 1 hr 40 mins to the three pages on residential and non-business charitable development, 50 mins to the nine lines on caravan pitches, and 3 hrs to the remaining 11 4/5 pages on land and commercial buildings — an average of about 15 mins per page.
Set out below are three of the many areas of difficulty still remaining. It should perhaps also be stressed that although since the measures were first announced last June many people have made an effort to understand them — seminars on VAT and property have been very popular over the last nine months or so — the draft clauses published in February were very different in several respects from the proposals in June, and the current shape of the legislation differs in a number of areas from the draft clauses. Accordingly, even those who have attended seminars may be unaware of all the difficulties in the final legislation. It therefore seems appropriate to start with the main change.
Commercial development from August 1 1989
The June 1988 consultation paper proposed a VAT charge on sales of building land. This proved unworkable, and the February 1989 draft clauses contained instead a tax charge on commencement of development in certain limited circumstances. With minor changes this was retained in the Finance Bill. However the Government brought forward an amendment to the Bill — too late for it to be properly debated — which abandoned this and replaced it by a somewhat nastier provision.
The details of this charge were considered by Tony Johnson in his article in our issue of May 27 (p 68). Suffice it to say here that if the construction of a building (or civil engineering work) commences after July 31 1989 and a freehold disposal — which triggers VAT at 15% — does not take place in the three years following completion of the building, a VAT charge will now arise on the first occasion in the 10 years following its completion on which a “developer” either:
(a) grants an interest in, right over, or licence to occupy the building which is an exempt supply; or
(b) is in occupation of the building at a time when he is not a fully taxable person (new para 5(1) and (3)).
Unless the “developer” has held an interest in the entire land on which the building stands throughout the 10 years up to the time when a reconstructed building is first ready for occupation, a similar VAT charge arises in relation to a reconstruction, enlargement or extension of (or annexe to) an existing building which increases the floor area by 10% or more.
The blame for this provision has been placed by the Minister, Peter Lilley, on the European Commission, which has claimed that the charge on commencing development departs too far from the Sixth Directive. In the past the UK has taken advantage of a derogation from the directive under which building land can be exempted. It is entitled to continue to do so. However, the Government (not the EEC!) considers that to continue the exemption now that new construction is taxable “would have introduced a massive fiscal incentive in favour of self-developments”. It does not say why this problem could not be dealt with under the self-supply rules, as it has done for labour costs, rather than imposing a VAT charge on virtually all development. So much for the justification of the charge. What about its effects?
As originally drafted, the Bill allowed a developer, in effect, to opt to charge VAT on his sale price by selling the freehold or to absorb the VAT on the land and construction costs, but avoid having to charge it on his profit element by instead granting a long lease at a premium. Bearing in mind that the object of the legislation was to comply with the European Court’s ruling not to raise revenue, this choice did not seem unreasonable and would help VAT-exempt traders. The amendment abolishes this option by imposing a tax charge on the full developed value of the building, including the developer’s profit, where it is leased (unless the option to tax is exercised). This will effectively force developers to exercise the option to tax even where the purchaser/tenant is a VAT-exempt trader.
An example will explain why. Suppose a developer buys a site for £2m, spends £4m on erecting a building and sells it on completion for £8m. He must charge VAT on £8m but claims relief for the input tax on the £4m construction costs, giving a net VAT bill of £600,000. Suppose instead of selling it he leases it for a premium of £8m and a nominal ground rent. The grant of the lease is an exempt supply, and being the first supply following construction will eliminate any ability to recover VAT on the construction costs. At the end of the VAT quarter in which the supply takes place there is a further deemed supply under the new paras 5 to 7 under which the developer is deemed to have sold the freehold of the building — and thus to owe Customs VAT of £1.2m on its £8m market value. By exercising the option to tax, the developer by passes paras 5 to 7 and thus retains the ability to recover VAT on the construction costs.
The loser is of course the bank, building society, funeral director or other exempt or partially exempt trader, who will now be charged VAT on the developer’s profit when it thought up to now that it would escape this. Such an occupier is even more severely hit on a refurbishment where prior to April 1 it paid VAT on the building costs alone, but must now pay VAT on the developed value of its building — including the land value that has accrued in its ownership and the notional building profit that it makes out of itself! If it has had an interest in the land for at least 10 years it escapes the charge on a refurbishment or extension — but if it has owned only 95% of the site and had to buy in the other 5% to make the extension feasible it will suffer a VAT charge on the entire value of the building!
The fun starts where there are several interests in a building. Suppose a person wants to redevelop his building. To raise finance he grants a 25% equity stake in it to an institution by granting it a lease and taking back a sublease. Unless the institution opts to charge VAT on the rents it receives it will receive a VAT bill, not on the value of its 25% interest but on the value of the entire freehold building! The Government’s view is that the institution needs to “reflect his liability for the charge on the freehold value in the terms he agrees with the freeholder”. It does not suggest how this might be done where there are a number of interests in the building and it is uncertain who will make the first exempt supply.
Anyone contemplating a development for occupation by an exempt trader can avoid these problems by commencing his development before August 1. If, that is, he knows what commencing the development entails. Under betterment levy, development gains tax, and development land tax, Parliament took care to define what such an important idea meant. Not so for VAT. The Bill is silent, although the minister has provided a definition. It must be borne in mind that Hansard cannot be used in an appeal to show what the legislation was intended to mean, although in this case it hardly matters as Mr Lilley’s explanation — “construction or reconstruction commences when on the particular facts a meaningful and ongoing start has been made to the construction process” — is not particularly helpful.
Deduction of input tax
Input tax can in general be deducted only if a person is a “taxable person” at the time he incurs the tax. Customs can (NB not must) allow a deduction for input tax incurred before a person was required to be registered. However, input tax on services cannot be deducted if it was incurred more than six months before the date of registration (VAT (General) Regulations 1985, reg 37). Construction work is either a composite supply of services or a mixed supply of services (labour) and materials which falls to be dissected into those two elements. Professional fees are for a supply of services. There has been no indication from the Government that it intends to amend the six-month rule which seems wholly inappropriate in the time-scale of property transactions.
The sale of a freehold or a lease of over 21 years is deemed to be a supply of goods (VAT Act 1983, Sch 2, para 4). Accordingly, in theory, Customs can allow the VAT paid several years earlier on acquiring a building to be set against the VAT on its disposal. There is no indication that they will, and it seems improbable. Certainly VAT on the building work (except probably the cost of materials) could not be reclaimed at that stage.
Particular problems can arise for charities where zero-rating applies on construction. If the building ceases to qualify for zero-rating within 10 years there is a deemed (taxable) disposal. The charity will have to pay VAT on the entire sale proceeds with no relief for VAT on professional fees incurred several years earlier.
If a developer buys a building which he intends to refurbish, he will often be forced either to forgo the ability to recover VAT on the refurbishment costs even if he exercises the option to tax the day he lets the building or to opt to tax immediately he acquires the building (if not before) even though he may not at that stage know who his tenant will be, or indeed if he will retain the building. The option to tax is illusory in such circumstances.
A developer of a new building who rents it to an exempt occupier could well not exercise the option to tax. If he later sells the building within three years of its completion he will have to account for VAT on the sale proceeds but will not be able to claim credit for VAT on the building costs incurred more than six months earlier.
Buildings completed but not occupied at April 1 1989
Where a building was completed before April 1 1989 but not fully occupied before that date VAT on the full sale proceeds must be paid on the first sale after that date. This was not in the February draft clauses. It was announced on March 10, a mere three weeks before April 1, and will have been missed by many people. Even if a developer had noticed it he would have found it difficult to find an occupier in such circumstances — even if he knew what “fully occupied” means, as it is another term that the Government cannot be bothered to define.
The reason for the change is that the Government received representations that a developer who had completed his building but not let it by April 1 would not be able to obtain relief for VAT on fitting-out costs. It seems incredible that to enable a few people to reclaim VAT on a tiny proportion of their building costs the Government should have to impose an unexpected VAT charge on the entire value of all buildings completed but not occupied before that date. Is this really what the protestors wanted? If not, they should make this clear to the Government. If it is, is it too much to expect them to reveal their identity to those fellow developers who have suffered from this last-minute change?
