VAT recovery denied on costs of some conversions

For many years there has been a VAT problem for developers who are converting a part-commercial, part-residential property into wholly residential properties.  The classic example is the conversion of a pub that also includes residential accommodation into flats.

The legislation allows the sale of a dwelling* created from a non-residential building or non-residential part of a building to be zero-rated, as long as the conversion results in the creation of additional dwelling or dwellings.  The benefit of this is that VAT on the conversion costs can be recovered.

However, what happens when the building is converted so that each resulting dwelling is created using both commercial and residential parts of the building?  HMRC’s interpretation of the law has always been that zero rating can apply only to the sale of a dwelling created wholly from the non-residential areas (as long as the other conditions are met).  However, tribunal decisions have not always agreed with this interpretation.  Most recently in the Languard New Homes Ltd case, the tribunal decided that the new dwellings created from both residential and non-residential parts could be sold zero-rated.

HMRC have now won an appeal against this decision at the Upper Tribunal.  Upper Tribunal decisions are binding and so developers selling dwellings created from residential and non-residential parts of a mixed-used building cannot sell dwellings zero-rated unless the dwellings are created wholly from the non-residential parts of a building.  Sales of dwellings created wholly or in part from the residential areas of the building are exempt from VAT.  This means that the VAT on the related costs may not be recoverable.

Developers acquiring mixed-use buildings for conversion to residential use should allow for irrecoverable VAT on costs, including on the purchase price of the building.  A proportion of the VAT may be recoverable depending on how the building is converted and so it is essential to understand the VAT position at the planning stage.

*”Dwelling” as defined by the VAT legislation.