What Does The 5% VAT Rate On Building Works Apply To?

Andrew Needham looks at how the 5% rate on building work applies to renovations and conversions of residential buildings.

The 5% rate on building works can produce useful cashflow savings for businesses and actual savings for individuals and businesses that cannot recover their VAT, such as buy-to-let, etc.  The 5% rate applies to the following main areas of construction works:

The 5% rate only applies to the services of a builder, and any materials that he supplies as part of the work he does.  If you buy the materials separately then you will have to pay the full rate of VAT on them from the builder’s merchants.  The standard rate also applies to services of architects, equipment hire, etc.

Many private individuals (and sometimes small builders) who are renovating or converting a house think that they can claim the difference between the 5% rate and the 20% standard rate back from HMRC.  This is not the case – the 5% rate is charged by the builder and you cannot claim back the difference from HMRC. 

 

The rules in this area appear simple at first glance, but don’t be fooled – they are complex and cause a lot of confusion.  In the simple scenario you have a house consisting of two flats and you convert it into one house – a change in the number of dwelling from two to one, so the 5% rate applies.  

But what happens if you have a three story block of flats containing three flats – one flat on each floor – and change it to five flats, two on the ground floor, two on the first floor and one on the second floor – surely the whole project is subject to the 5% rate because you have a change in the number of dwellings from three to five?  Unfortunately it is not that simple – you have to look at the building work on a floor-by-floor basis.  In this example, the 5% rate will apply to works on the ground and first floors (number of flats changed from one to two) but not to the second floor as it still only has one flat, so there has been no change in the number of dwellings and the standard rate of 20% would apply to that part of the work, so an apportionment would be necessary.

It’s a common scenario; a business owns a commercial property on the edge of a town centre, which has been empty for some time as the owner cannot find a commercial tenant in these difficult economic times.  The building is now used as offices, but it was originally used as a large house.  The owner intends to convert it back into residential use as three flats, which can be sold following conversion.  The building work would be subject to VAT at the 5% rate, but in order to reclaim any of the VAT incurred the property would have had to have had no residential use for at least ten years for the sale to be zero-rated, otherwise it would be an exempt supply and the VAT would be irrecoverable.

Another related problem occurs when a business converts a part commercial and part residential property into all residential use and then intends to sell them on.  For example, if you have a pub with the manager’s flat above and decide to turn it into one big house the 5% rate will not apply as you started with one dwelling (the manager’s accommodation) and ended with one dwelling, so the 20% rate will apply to all the work.  To make matters worse, as the ‘new’ house contains the old manager’s flat the sale cannot be zero-rated and you cannot recover any associated VAT as it will be an exempt supply - so you have a double whammy.

For both residential conversions and a change in the dwelling conversions the evidence to support the 5% rate is obvious from the plans and planning permission and should be retained in case HMRC make an inspection.

In order to qualify for the 5% rate the property has to have been empty for two or more years.  However, if you are the builder you will need to obtain evidence that the property has been empty for more than two years.  HMRC recommend that you obtain the evidence from the ‘Empty Properties’ officer of the Local Authority.  Typically of advice from HMRC, most Local Authorities do not have an Empty Properties officer so you are best consulting Council Tax records or the Electoral Roll showing the property has not been occupied for two years.  

In the case Gurpreet Singh Bhachu v Revenue & Customs [2013] UKFTT 498, the builder accepted the word of the client that the building had been empty for more than two years.  When HMRC inspected him they requested proof, which he could not obtain from a rather unhelpful Local Authority.  In the absence of any supporting evidence, the Tribunal found for HMRC. 

Note that the two-year period runs up to the point that the building work starts, not when it is completed.

The use of the 5% rate has proved very beneficial to property investors, whether working on a ‘buy-to-sell’ or ‘buy-to-let’ basis.  This can give very worthwhile savings, but not just to property developers; it can also give savings to private individuals as well.   If you are a business and can reclaim the VAT, it can provide a useful cashflow saving, but if you are a private individual or a business that cannot recover its VAT this provides an absolute saving.

Example - Potential VAT saving

If the costs of converting the offices into flats would be £65,000, the VAT on this would normally be £13,000 (£65,000 x 20%).  

Doing your research and getting the VAT liability right means the correct VAT should be £3,250 (£65,000 x 5%) giving a VAT saving of £9,750.

Even after 13 years smaller builders are not aware of the 5% rate for qualifying projects so show him HMRC’s guidance on this in sections 7 and 8 of Notice 708 (see the HMRC website).  There is no need to provide him with any kind of certificate, just proof that the project qualifies.  

If you are having a building renovated make sure you get the correct VAT rate charged and don’t buy the materials seperately unless you can recover your input VAT.  If you are a builder make sure any work you undertake qualifies for the 5% rate and obtain proof in the form of planning permmission, architects plans or evidence that the building has been empty for more that two years.  If you fail to do so, HMRC may issue you with an assessment for undercharged VAT.