HMRC begin by explaining how the ‘first grant of a major interest’ (i.e. freehold grant or leasehold grant over 21 years) in a residential property is zero-rated. All subsequent grants are then exempt.
When a residential property is constructed or created by the conversion of a non-residential property, all input tax is recoverable against the first grant of a major interest. However, if a residential property is constructed and the first grant of a major interest is a long lease, the developer is using the building for a business purpose other than solely for the purpose of selling the building.
As such, the developer will have to treat the building as a capital item under the provisions of the Capital Goods Scheme (‘CGS’). The construction input tax recovered against the zero-rated long lease will have to be adjusted through the CGS should any subsequent exempt grant be made of the building.
If a developer constructs a residential property, and the first grant of a major interest is a freehold sale, the developer is using the building for the purpose of selling it, and does not have to treat it as a capital item under the CGS.
HMRC give three examples of how the above provisions would work as follows:
(a) All flats sold followed by the freehold - The sale of each individual flat will be a zero-rated first grant of a major interest. HMRC say that although the developer will hold a capital item, when the freehold is sold, they consider that it will only be exempt to the extent that it relates to those areas of the building that were previously the subject of the zero-rated grants of individual flats. Most of the sale of the freehold title will be zero-rated because it relates to the common parts that have not been subject to any previous supply.
These circumstances are part of the sale of new dwellings for which the zero-rating was designed. Furthermore, any CGS adjustments would be negligible, so there is no need to make any in this example.
(b) Freehold sold before any flats are sold - The sale of the freehold will be a zero-rated grant and as no leases had been granted, the building would not be a capital item by virtue of Reg. 112(2), VAT Regulations 1995. Consequently, all the input tax incurred on the construction costs will be fully deductible.
As the new freeholder, the purchaser will make exempt grants of leases to buyers of flats. Even where the consideration for such sales accrues to the developer, so that VAT law treats the developer as the person supplying the flat, this will not impact on the initial deduction of input tax by the developer. It may, however, have implications for any input tax incurred on selling costs.
(c) Freehold sold after some flats have been sold - The flats sold before the freehold has been supplied will each be a zero-rated first grant of a major interest. As per example (a), whilst the developer will hold a capital item, when the freehold is sold, we consider that this will only be exempt to the extent that it relates to those areas of the building that were previously the subject of the zero-rated grants of individual flats. Most of the supply of the freehold will be zero-rated relating to the common parts and unsold flats that haven’t been subject to any previous supply. As such, no CGS adjustments are needed.
If, under the agreement for sale, the developer has retained the right to receive the monies from the sale of the remaining unsold flats, the considerations set out in example (b) apply.
HMRC add that the first grant of a major interest in a ‘relevant residential’ property, such as a care home, is also zero-rated, and that under Reg. 116(3) VAT Regulations 1995, (used for determining any CGS adjustments in subsequent years) the developer disregards any exempt supply arising directly from that grant (including all rents due under that lease). Even though the developer holds a capital item, provided no exempt supplies are made other than those arising from that zero-rated grant, full deduction of the input tax on the construction of the development will remain.
Where, however, the developer makes a new grant like selling the freehold, this will be an exempt second grant in the building. In this situation, CGS adjustments are likely to be required, and CGS calculations must be carried out.