The complexity of VAT legislation affecting property transaction is well illustrated by the number of tribunal decisions in this area that are seemingly completely at odds with the rulings of earlier tribunals. Creating new dwellings by the conversion of an existing commercial property, where there is also an existing residential element, is an excellent example of this complexity, and is a situation we are frequently called upon to advise.
Consider the example of a developer converting a building comprising a shop on the ground floor, with a storage area plus two flats above. The property is to be converted such that it will ultimately contain three dwellings. The conversion can be done either:
1. horizontally (such that the former shop area now becomes one of the dwellings and the upstairs flats are each extended to include part of the former storage area); or
2. vertically, so that each of the dwellings contains a part of the previous shop and a part of one (or both) of the previous flats.
Traditional wisdom would say that, if route 1. is followed, the grant of a long lease in the ground floor dwelling will be zero-rated (enabling the developer to recover input VAT on the conversion costs for that dwelling) because the dwelling has been created in an area that was previously 100% non-residential. However, the grant of a long lease in the upstairs dwellings will be VAT-exempt (preventing recovery of input VAT) because part of the area that they each occupy was residential previously.
But if route 2. is pursued, the grant of a long lease in any of the dwellings will be VAT-exempt, hence the developer recovers no input VAT.
This difference in VAT treatment between the horizontal and vertical conversion was recognised as being a ludicrous consequence of the legislation by the tribunal in the Calam Vale case in 1999. Nevertheless, the tribunal considered that the legislation forced it to conclude that the VAT treatment would indeed be different for the two scenarios.
This anomaly was seemingly remedied by the subsequent tribunal decision in Alexandra Countryside Investments Ltd in 2013, where the taxpayer converted a pub containing a flat into two houses, each of which included part of the flat and part of the previous commercial area. Here, the tribunal ruled that, the starting point was to recognise that the number of dwellings in the entire building had increased as a result of the project, and based on its interpretation of the legislation, the tribunal considered that this meant the sale of each of the new dwellings could be zero-rated.
Based on this decision, the developer in our example would be able to zero-rate the long lease in each of the three dwellings. Unfortunately, this seemingly good news for our developer has been short-lived. In considering the cases of MacPherson and Languard New Homes Ltd earlier this year, the Upper Tribunal ruled that, not only must the number of dwellings in the building be increased as a result of the project, but also a new dwelling must be created entirely from an area that was previously non-residential, if zero-rating is to apply to the sale or the grant of a long lease.
Therefore, as far as our developer is concerned, the VAT position has been returned to how we had traditionally assumed it to be, with the differing VAT treatment for the horizontal and vertical conversions. But now that is not quite the end of the story – suppose when converting the shop area, our developer decides to also convert the top floor into a single flat. Because the entire building originally contained two dwellings, and will continue to do so after the conversion project, no additional dwellings have been created; hence the long lease in the new ground floor flat can no longer be zero-rated, thus meaning the developer now cannot recover the VAT on any of his costs! Purely from the VAT perspective, he would be well advised to carry out the ground floor conversion first as a separate project, so that there will be three dwellings in the property, at least for a short time.
It is therefore perhaps little wonder that the Upper Tribunal stated in MacPherson and Languard New Homes Ltd that it had reached its conclusion “with some hesitation”, given the arbitrary way in which the legislation seems to apply in this area.