VCONST02900 - Zero-rating the construction of buildings: Capital Goods Scheme (CGS)

When a developer’s first grant of a major interest, in a building that he has constructed, is a long lease he will be making a business use of it as opposed to simply selling it and therefore the building must be treated as a capital item.

The first grant of a major interest (freehold sale or lease exceeding 21 years) in residential property by its developer is zero-rated, under VAT Act 1994, Schedule 8, Group 5. However, all subsequent grants in the property are VAT exempt. VAT on costs relating to zero-rated supplies is fully recoverable whereas VAT relating to exempt supplies is not normally recoverable.

Further information on partial exemption can be found in Notice 706 Partial exemption and on the capital goods scheme in Notice 706/2 Capital Goods Scheme.

Attribution of input tax

When a residential property is constructed or results from the conversion of a non-residential property and the developer makes a first grant of a major interest in that property, any input tax incurred is recoverable in full. This is because the input tax is wholly attributed to that taxable first grant.

This is the case even where the value of the first grant does not represent full equity in the property, such as in shared ownership schemes run by housing associations.

Application of the Capital Goods Scheme (CGS)

Regulations 112(2) and 113 of the VAT Regulations 1995 set out when a building will be a capital item for the purposes of the CGS.

If a developer constructs a residential property and the first grant of a major interest in the building is a long lease, he is using the building for a business purpose other than solely for the purpose of selling the building. As a result, the developer will have to treat the building as a capital item. The input tax incurred on the construction of the building and wholly attributed to the zero-rated long lease will have to be adjusted through the CGS should a subsequent exempt grant be made of the building.

If a developer constructs a residential property and the first grant of a major interest is the sale of the freehold, the developer is using the building solely for the purpose of selling the building and will not have to treat the building as a capital item.

Examples

There are essentially three ways a developer might grant all the leases and the reversionary interest in the freehold of a residential property (typically a block of flats):

(a) All flats sold followed by the freehold - The sale of each individual flat will be zero-rated as first grant of a major interest. While 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 sale of the freehold 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. Accordingly there is no need for CGS adjustments in this example.

(b) Freehold sold before any flats are sold - The sale of the freehold will be a zero-rated grant and since no leases had been granted, would not be a capital item (by virtue of Reg 112(2), VAT Regulations 1995). Since the freehold is zero-rated, all input tax incurred on the construction costs will be fully deductible.

As the new freeholder, the purchaser will normally make any 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. While 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 per example (a) above, 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) above apply.

Other residential property

The first grant of a major interest in a relevant residential property (for example a care home) is zero-rated. Under Reg 116(3), VAT Regulations 1995, in 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, providing he makes no exempt supplies other than those arising from that zero-rated grant, he will retain full deduction of the input tax on the construction of the development.

However, if the developer makes a new grant, like selling the freehold, this is the second grant in the building and will be exempt. In this situation CGS adjustments are likely to be required and CGS calculations must be carried out.