The recent (July 17) case concerning Languard Homes is of interest to anyone contemplating a commercial to residential conversion and of particular relevance to pub conversions.

One of the peculiarities of the VAT system is how it treats residential building conversions. When the building being converted has only been used for commercial purposes then things are fairly straightforward – the sale of the new residential flats can be zero rated and the VAT incurred recovered.  The difficulties occur when the building being converted also contained a residential area. Examples might be a pub with a staff flat above a pub or shops with flats above or an office building with a caretakers flat.  The question is whether the sale of the flats that are created when such buildings are converted will be zero rated , which will allow the recovery of the VAT incurred on their conversion .

The rules are clear if the flats are created in parts of a building that have previously had an exclusively business or residential use. When the footprint of a new flat is entirely within an area of a building that has only been used for commercial purposes, such as a pub bar area, then its sale will qualify for zero rating. VAT incurred on related costs can be recovered. When a flat is converted out of part of a building that has had only residential use, such as a staff flat, then the sale won’t be zero rated but VAT exempt and there will potentially be no VAT recovery.

Taking the example of a pub conversion. Assume  a two story pub with a staff flat above is converted into two flats, one on each floor. Here the sale of the ground floor flat will be a zero rated and the upper floor will be exempt. The developer will obtain partial VAT recovery

Where the problem arises is when the new flats incorporate both commercial and non commercial areas of a building. Here it is HMRC policy that the law means that if a new conversion flat makes use of any area that was previously residential, then regardless of degree,  its sale cannot be zero rated but is VAT exempt. So if you decided to convert a pub into two maisonettes that each used part of the downstairs bar area and part of the residential upper floor flat then the sale of both flats would be exempt. You would obtain no recover of the VAT incurred on converting the building. Put another way the VAT system encourages horizontal conversions and discourages vertical ones.

Not surprisingly this anomaly has led to litigation before the VAT Tribunal, which has found both for HMRC and against. To resolve the question it need to go before a higher court – the Upper Tribunal. This has happened now in the case of Languard Homes (see Languard Decision) where the Court agreed, rather reluctantly, wth HMRC that a vertical pub conversion conversion meant there was no zero rating.

As one of the earlier VAT Tribunal Judges mentioned in their decision this does mean that the VAT legislation has a very odd consequence. For example if there was a 5 story office building with the 5th floor being a caretakers flat then one approach to conversion would mean that 80% of the development qualified for zero rating and the other 0%. A recovery difference like this might be worth quite a lot of money and clearly might discourage the creation of flats that have easy access to individual gardens and better satisfy planning guidelines.

Although the current position is clearly wrong will it change ? Well first we have to see if there is an appeal – the Court expressed reluctance at reaching its conclusion and although its decision  judgment is very clear, a higher Court might take a different view. If not then as of today HMRC don’t have great room for manoeuvre. They perceive their ability to issue extra statutory concessions to have been restricted by the House of Lords in the Wilkinson case and they have no real ability to expand the UK zero rates under EU law. But this might well be changing. If we leave the EU then clearly ministers can change the law in this area if they wish, but even if we stay there is a move to member states having more autonomy over VAT rates. It is anomalies like this that help give VAT a bad name and I hope the law can be changed soon.

If you are converting a building in the meantime it pays to take VAT advice. There are frequently cases on construction which change policy and often ways round difficulties. For my guide to property VAT see Property Guide To get in touch click contact me