Chip off the old VAT block: understanding the zero VAT rate for construction
TaxTalk - Autumn 2024
We outline the importance of understanding the zero VAT rate for those involved in the construction and the residential property industry.
Businesses involved in the construction and supply of buildings used for residential purposes often assume that their supplies are entirely or predominantly subject to the 0% VAT rate. The reality is far more nuanced and this article highlights examples of the areas that, in our experience, are frequently misunderstood or misinterpreted (particularly in the care home sector).
Summary of the relevant rules
I could fill up an encyclopaedia with the regulations and case law surrounding the zero rate for qualifying buildings; HMRC’s VAT Notice 708 however, does a stellar job of diving into the detail.
For the purposes of this article, the following is key:
- The service of constructing a new building generally attracts VAT at the standard rate (currently 20%). However, where the construction services relate to certain new qualifying buildings, the zero rate may apply.
- The first sale of, or the first grant of a long lease in, a new qualifying dwelling or communal residential building by the person constructing it also may be eligible for zero-rating.
Qualifying buildings include:
- A building designed as a dwelling
- A building that will be used solely for a relevant residential purpose (e.g. a care home)
- In order for a builder to zero-rate its construction of a building to be used solely for a relevant residential purpose, the builder must receive a certificate from the end-user confirming that this is the case.
- In order for a developer to zero-rate its first sale, or its first grant of a long lease in, a building that will be used solely for a relevant residential purpose, this builder must receive a certificate from the purchaser / lessee confirming that this is the case ahead of the sale / lease.
Issue 1 – What happens when construction services are not supplied to the end-user?
This frequently occurs in the care home sector. The industry typically implements a structure whereby an investment company (“PropCo”) incurs all the land and construction costs for a new care home. PropCo subsequently grants a long lease of the new care home building to a care home operating company (“OpCo”).
Here, the recipient of the construction service, (PropCo) is not the end-user of the building and therefore cannot certify that the building will be used for a solely relevant residential purpose. Consequently, the builder does not have the option to zero-rate any element of its construction services and must charge 20% VAT on all its services. This creates a cash flow cost in the investment company and we recommend filing VAT returns on a monthly basis to help manage this issue.
Issue 2 – Can developers recover all the VAT incurred on care home construction and fit out costs?
The short answer is no. VAT recovery in this scenario can get very complicated and we are often called upon to clean up the mess when VAT has been over-recovered or under-declared and a significant disclosure to HMRC is necessary.
As outlined above, the first grant of a major interest (e.g. a lease of more than 21 years in England) in a qualifying relevant residential building (such as a care home) by the person constructing it (PropCo) can in principle be zero-rated. If all the conditions are met (certificates etc), the VAT incurred by PropCo on the construction costs should in principle be recoverable because the VAT incurred directly relates to its 0% VAT rated supply to OpCo.
However, the VAT legislation specifically blocks recovery of VAT on certain incorporated goods (e.g. carpets, most fitted furniture) when the VAT incurred relates to an onward zero-rated supply. In our experience, PropCos routinely do not apply the blocking rules correctly resulting in an over-recovery of VAT. This is not entirely surprising as the builders’ construction invoices either do not identify the items that should be blocked from VAT recovery or do so incorrectly. PropCos are then left with the onerous task of identifying the goods that were incorporated into the building and then analysing which incorporated items do not qualify for VAT recovery.
Furthermore, where non-incorporated loose items are included as part of the long lease (e.g. tables, chairs, beds, electrical items), VAT incurred on such items is recoverable, but output VAT needs to be charged on the value of these items. In our experience, care home businesses are not aware of this rule and the exercise to correct this can be time consuming and expensive.
Next steps
The VAT rules on land and property are highly complex and this article only touches the tip of the iceberg. We recommend that any business involved with residential development takes detailed advice in advance. Preparing a road map ahead of any development should help to better manage costs, improve profit margins and avoid painful penalties.
Please don’t hesitate to contact Mark Ellis or Natalie Braier to discuss further.