If not properly recoverable VAT can effectively wipe out profit margins. Developers must be alive to the circumstances in which an option to tax can be disapplied making VAT irrecoverable.
Serious practical difficulties in the recovery of VAT can be caused when a tenant who is making exempt supplies is deemed to be "funding" a development. This problem is compounded by the recent bank restructurings. The Government's intervention has created a majority shareholder in two major banking groups that could have the inadvertent effect of preventing either group from financing a development in which the other is to be a tenant, if VAT is to be recoverable.
It is industry practice in the pre-let of a property to accommodate a tenant's requests for changes to the specification of a building and recharging the costs. This becomes complicated where a tenant provides mainly exempt supplies for the purposes of VAT, such as working within the financial sector.
Anti-avoidance arrangements entitle HMRC to disapply an option to tax
Anti-avoidance legislation brought in by the Finance Act 1997 was intended to prevent schemes designed to reduce the cost of irrecoverable VAT to entities making exempt supplies and, in certain circumstances, it allows HMRC to disapply an option to tax. Broadly, the option to tax will be disapplied where, at the time of the supply, the following conditions are met:
- The land or building to which the option is to apply is a capital good scheme item in the hands of the person making the supply or the person to whom the land is to be transferred.
- The intention or expectation of the grantor or a person responsible for financing the grantor's development of the land is that the property will be occupied by them or a connected person.
- The property will be put to an exempt use.
A developer may fall foul of these provisions if a tenant who is making exempt supplies assists in the funding of a development.
This anti-avoidance legislation does not include rental payments which are normal supplies, but could encompass contributions towards fit out and any variations to the developer's specification with the contractor which are recharged to the tenant through the developer.
Difficulties in recovery of VAT could be the result
In the absence of a de minimis exception, even minor variations, if accommodated in this way, could wipe out the recovery of VAT, and consequently any profit margins. With the Government's bailout resulting in a mutual majority shareholder of both the RBS Group and the HBOS/Lloyds group, a developer with RBS as a tenant and HBOS as a funder may now have some difficulty opting to tax the property. Now that these two groups have a mutual shareholder, it is unclear if they have now become "connected persons" for the purposes of section 839 of the Income and Corporation Taxes Act 1988, and HMRC is understood to be taking legal advice on this. The effect would be that any development tenanted with a member of either banking group could find it difficult to recover VAT where funding came from any member of either group, making difficult relationships between the banks and the property sector even harder.
This issue can create real costs if it is not noticed or addressed quickly enough. Clarification is urgently required on whether the banks are to be deemed to be connected parties as a result of the restructuring. Legislation would be reasonably required to clear up an inadvertent effect of the bank restructuring if the Government is to take a serious approach to rehabilitating the financing difficulties of the property industry.