Nigel Roberts

A recent Court of Session decision has highlighted the complexity and risk in the VAT zero-rating rules for many types of communal residential buildings, care homes and charities. Not understanding these rules can lead to substantial VAT costs which can arise many years after the building was completed.

The recent decision in Balhousie Holdings Ltd v HMRC should be essential reading for any property developer or occupier of communal residential or charitable buildings. It highlights just how easy it is to fall foul of the complex VAT rules governing zero-rating for the construction and sale of such buildings and create a large irrecoverable VAT cost, sometimes years after the property was brought into use.

It’s fairly well understood that the construction or first sale of a freehold or long lease (more than 20 years in Scotland) of a dwelling (a house or flat) is zero-rated. This is an important relief that removes a big VAT cost from the new housing market.

The relief extends to two other categories of building - so called Relevant Residential Purpose (RRP) and Relevant Charitable Purpose (RCP) buildings. RRP buildings include communal dwellings such as student halls and also care homes. RCP covers buildings used by charities for non-business purposes.

When zero rating applies

There are important differences between the zero rating relief for dwellings and for RRP / RCP buildings.

Firstly, the RRP / RCP relief is based on the use to which the building is put, not the form of the building. Because a developer can’t guarantee this use, the user of the building has to formally certify it.

Secondly, because of this certification procedure, zero-rating is only available for a supply by the party to whom the certificate is issued, not right down the sub-contractor chain.

Thirdly, because use can change over time, anti-avoidance legislation gives HMRC a right to clawback tax on a RRP/RCP development if the person issuing the certificate changes the use of the building to a non-qualifying within 10 years of it coming into use. It was this provision that Balhousie fell foul off.

Change of use for the purposes of the clawback provision includes a disposal of the owner’s entire interest in the property. A company in the Balhousie group had a care home built and issued a certificate to obtain zero rating. It ran the home for a period then entered into a sale and lease back with a related company. The sale represented a disposal and triggered a VAT charge equivalent to the VAT that would have been charged on the construction if no certificate had been issued (subject to time apportionment for qualifying use). This VAT was irrecoverable by Balhousie.

The key point in the litigation was based on HMRC’s acceptance that had Balhousie entered into a lease and lease back, the VAT charge would not have been triggered - because the lease out would not have been a disposal of Balhousie’s entire interest. Through three rounds of litigation Balhousie argued that there was no economic difference between a sale and lease back and a lease and lease back, so it was unfair that only one should trigger a VAT cost.

The Court of Session ruling

Unfortunately, the Court of Session didn’t accept this. It pointed out that VAT is a tax on transactions and that a lease is legally a different transaction to a freehold equivalent disposal - with different tax consequences. The VAT cost stayed.

This decision highlights the complexity of the zero-rating rules for RRP / RCP buildings and the unforgiving nature of the change of use rules. It is vital that anyone who owns and operates such a building keeps full records of its development history and treats any disposal or possible change of use with great care. Equally, anyone acquiring such a property should ensure they undertake a full review of the building’s history and in particular the issue of any zero-rating certificate. Failure to do so can be expensive.