A difficult phase for development projects

A recent First-tier Tax Tribunal decision emphasises the care needed when phasing development projects if valuable VAT reliefs are not to be lost (York University Property Company Ltd v HMRC). 

Legal background

One of the key VAT issues with phased projects is that:

• construction services (other than some professional services) provided in relation to a new building to be used for certain residential or charitable purposes can be zero-rated for VAT purposes; but
• this zero-rating only applies to the construction of the original building, and specifically does not usually apply to any subsequent enlargement of, or extension to, that original building.

Developments may need to be phased for perfectly sensible commercial reasons (not least, the availability of funding). But if they are, the question arises as to whether or not the later phases of works complete the original building (zero-rated), or relate to an extension / enlargement of that building (standard-rated).

In practice, this distinction often matters most in the education and healthcare sectors, where the potential availability of zero-rating, and the strain on funding, mean phased developments which might benefit from zero-rating are common. Of course, in those sectors any VAT incurred is often largely irrecoverable.

The Tribunal case

In the present case, a subsidiary of York University constructed a research building for the university’s chemistry department. The planning permission for the new building envisaged two phases of construction:

• Phase 1 of the development was completed in August 2004 (and included a “sacrificial wall” along one side of the building, designed to be easily removed when Phase 2 was undertaken). The building was occupied by the chemistry department from September 2004.
• Phase 2 of the development was delayed until a generous donation made its funding possible. The phased works began in 2011, the sacrificial wall was removed, and the new area was completed in 2013 (at which point the chemistry department occupied the enlarged area).

It was agreed by HMRC that the works for both Phase 1 and Phase 2 related to a building to be used solely for a “relevant charitable purpose” (university research buildings can sometimes benefit from this classification). However, HMRC sought to deny zero-rating for Phase 2 on the basis that this was not the completion of the original building – instead, it was an extension to it.

The Tribunal sided with HMRC, and denied zero-rating for Phase 2.

While the case does not really break any new ground in terms of law, it does contain a very useful summary of the principles which will be applied to this kind of question. These include:

• It is a question of fact and degree as to when the original building can be said to come into existence (so that works thereafter become standard-rated for VAT purposes).
• That question is based on an examination and comparison of the physical character of the building as it would be after the works were completed – taking into account similarities / differences in appearance, the layout and how the building is equipped to function.
• There must be a sufficient temporal link between the earlier works and the later works, taking into account both the reason for and the length of any delay.
• A relevant question is whether the ordinary reasonable person, with knowledge of the facts, would regard the later building as an enlargement / extension of the original building or not.
• The mere fact that the later works are included within the original planning permission does not, of itself, mean the later works complete the original building rather than extending it.
• Both the subjective intentions of the taxpayer as to the building’s future use and the terms of the planning permission regulating the future use of the building are largely irrelevant.

Taking all these factors into account, the Tribunal concluded that the Phase 2 works could not be said to complete the original building, and accordingly did not benefit from the zero-rating applicable to the Phase 1 works. Although the Phase 2 works doubled the size of the research building, they did not really change the appearance, layout or function of the building. The building was occupied after Phase 1 and essentially complete at that point – it was used by the chemistry department as a research building for nine years prior to completion of Phase 2 (albeit not in fulfilment of the university’s wider “vision”).

Taxpayers do not typically win many of these phased development cases. One notable exception (Hoylake v HMRC) highlights the approach as well as the shortcomings of the taxpayer’s position in the current case. In Hoylake, there was a gap of only 18 months between initial development and the subsequent construction of kitchen and laundry block, those latter elements were essential to the function of the building, and were in fact required by the Commission for Social Care Inspection. The phased construction of the research building for York University shared none of these features.

In a world where funding difficulties remain common, and phased developments are accordingly not unusual, careful VAT planning is required to try to make sure taxpayers are not left with these kinds of expensive VAT liabilities.