VAT Implications of Short Term Letting of New Residential Properties

Monday 3 November

When the current economic climate is making it difficult for house builders to sell their properties, is short term letting the answer? What are the VAT implications?

What are the basic VAT rules?

When the outright sale or long lease of new residential properties is zero-rated (VAT at 0%), house builders can reclaim the VAT that they incur on development costs. Typically, this would be on land and professional fees. Some VAT, such as that incurred on 'white goods' is however specifically excluded from recovery.

In contrast, letting a new residential property under a short term tenancy ie not a major interest, is exempt from VAT. Although the consequences for the tenant/purchaser are the same in that there is no VAT on the payment to be made, the consequences for the developer are very different. This is because the VAT incurred on development costs is generally not recoverable if exempt supplies are made.

How does this affect property developers?

In the current economic climate, some developers are experiencing difficulties in selling their properties. They are then left with the choice of either leaving them empty or letting them whilst trying to secure a sale.

Although the short term letting may generate an attractive income stream for the developer, it creates a VAT problem because the development costs will have been incurred to make both taxable and exempt supplies. The VAT attributable to exempt supplies has to be calculated and cannot be recovered (subject to a de minimis limit.) Therefore the short term lettings can cause a claw back of VAT already recovered.

The VAT recovery of developers who have let their newly built developments on a short term basis prior to sale, is being critically reviewed by HM Revenue and Customs (HMRC). Where there is any doubt that the original intention was to construct the property for sale, rather than rental purposes, HMRC takes the view that all of the VAT previously recovered should be repaid. Even where it can be demonstrated that there was an intention to sell from the outset, some restriction on input tax recovery will normally be required.

Any repayment of large amounts of VAT in this way would obviously have a significant impact upon the profitability of development projects putting a further strain on developers in an already difficult financial market.

What could developers do?

One option for property developers facing the possibility of a claw back of VAT would be to make the first grant of a major interest in the property to a connected entity (who would not be a member of the same VAT group). This zero-rated sale might remove the need for any kind of adjustment, and could be done by creating a special purpose vehicle to own and let the investment properties.

The connected person would then rent out the properties until such a time as they could be sold. As the rental income would be exempt for VAT purposes, the related input tax (including that incurred on the eventual sale of the property) could not be recovered. However, the developer would not have to repay any of the VAT incurred on the development costs.

What is HMRC's view of the arrangements?

HMRC has recently issued new guidance regarding transactions involving the supply of new dwellings. Lorraine Parkin, a VAT partner at Grant Thornton says: "The new guidance is a welcome clarification from HMRC providing some certainty to housebuilders in difficult economic times."

She adds, "HMRC has confirmed that, in the main, arrangements for the sale of new domestic property to a connected entity are not abusive in nature and so are acceptable. However, the guidance also states that where the arrangements have certain features, they are likely to be challenged. Given that possibility, it will still be essential to seek advice, on other tax implications as well as VAT, before putting any such arrangement in place".

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