Commercial to residential: the VAT minefield
Acquiring commercial sites to convert to residential use is proving an increasingly popular strategy among property developers.
There seem to be several factors driving this trend. These include good availability of vacant commercial sites, and a growing demand for residential space. In addition, commercial locations can carry permitted development rights, which ease planning restrictions for developers.
A word of warning, though: turning a commercial development over to residential use is a VAT minefield.
It’s very different to developing bare land, for example, or redeveloping an existing residential site. These arrangements rarely expose developers to the most intricate aspects of VAT.
Converting commercial to residential, however, does have some extremely complex VAT implications. It’s easy to get caught out, and the cost of doing so will hit development profits.
Let’s take a look at some of the pitfalls. And I stress ‘some’ – the list below isn’t exhaustive.
Pitfall 1: Election to waive exemption:
Developers will know that commercial property begins life exempt from VAT. But owners may have waived that exemption (sometimes known as “opting to tax”) at some point during their ownership of the property.
If the vendor has taken this option on the site you’re acquiring, then 20% VAT will be added to your purchase price.
Before finalising contracts, therefore – and preferably before agreeing on Heads of Terms – you need to check whether the owner has elected to waive the VAT exemption. Otherwise, you could end up with a large, unexpected VAT bill.
Pitfall 2: Reclaiming VAT:
You’re probably thinking that the obvious solution to the above scenario is simply to reclaim the VAT.
In most cases, you’d be right. Though bear in mind that it takes several months, which will impact cash-flow.
But to reclaim VAT, you will, of course, need to be VAT registered. And that’s where the delay lies. Developers often use Special-Purpose Vehicles (SPVs) to purchase sites, which are rarely VAT-registered.
You can apply to HMRC to register an SPV for VAT, but it’s not a user-friendly process. Many applications are delayed or rejected because the case isn’t presented properly. You’ll need technical advice to help present your case, and to ensure your application is approved with minimum delay.
Also, care must be taken over the date on which you register for VAT to ensure you maximise your VAT recovery.
Pitfall 3: The SDLT premium:
Stamp duty land tax (SDLT), currently set at rates of up to 5%, is charged on the gross purchase price of the property. So, if your vendor has elected to waive VAT exemption on the site you’re buying, this will increase your SDLT liability – whether or not you subsequently reclaim the VAT.
Pitfall 4: TOGC:
There will be further complexities if the site you’re acquiring isn’t completely vacant.
Taking over tenants in a building that is already let means your purchase may come under the Transfer of Going Concern (TOGC) rules, which will have VAT implications.
The key word here is ‘may’. Whether your transaction constitutes a TOGC or not depends on several factors: the terms of the sale contract, the commercial relationships and terms of the rental contracts between the vendor and the tenants, and a host of requirements to be VAT registered and opting to tax.
TOGC sales are ignored for VAT purposes, which is obviously beneficial for developers buying sites, as it avoids pitfalls 2 and 3. But vendors may not deal with this as strictly required, and could end up charging VAT.
What’s more, any VAT paid on a TOGC in error is NOT refundable by HMRC.
Pitfall 5: Mixed-use:
Converting a commercial site to wholly residential use is one thing but developing it for mixed-use creates yet more complexity.
Commercial units are treated differently for VAT purposes than residential ones, which affects the VAT you can recover on any expenditure, and the amount to charge on an eventual sale. What’s more, the VAT status of the commercial space will differ depending on whether it’s sold freehold or as a long lease.
So, whether you acquire a commercial site that is VAT-exempt or opted to tax, you need to consider your own strategy for waiving VAT exemption. Your decision will depend on your proposals for the site, and on the need to avoid a troublesome VAT position – for yourself and for potential buyers.
This also applies to a situation where a mixed-use site is acquired for redevelopment where there could be multiple VAT effects on the treatment of sales and both recoverable and irrecoverable input VAT on supplier costs. The VAT analysis and impact will be individual to each site and must be approached in that way to avoid surprises. Further, for more complex schemes where the configurations of the development may change during planning as a result of specific planning requirements, these could sometimes lead to significant VAT implications for the developer if not fully considered.
Pitfall 6: Renting the finished units:
Whilst this is not just an issue for commercial to residential schemes, we know it’s not always possible to sell every unit on completion and some developers may decide to rent some of the stock to keep some income flowing. This puts the developer within the realm of making exempt supplies (rental) and creates a partial exemption situation that could lead to a clawback of VAT that has previously been claimed on the construction of the residential units. Because we are aware of this as an issue, we work with our clients to put plans in place to mitigate the potential VAT clawback or eliminate it completely.
The right solution:
There’s never a black-and-white solution to these scenarios. In each case, the right approach will depend on the nature of your business, the details of the site you’re acquiring, and your plans for its development.
Demand for commercial sites is high, and you’ll need to move fast to snap them up. But you must take time to consult a technical expert on the VAT implications first. Somebody who not only understands the rules but can interpret what they mean for your business.
For more information on The VAT minefield, please contact:
Cetin Suleyman - Managing Partner - firstname.lastname@example.org
For other blog pieces like this, check out our latest Briefing Notes: Issue 94, which can be found here.