VAT treatment of remedial cladding works - zero is the hero


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As any residential landlord may be aware, VAT incurred on costs relating to its rental business will not be recoverable. Such irrecoverable VAT is an additional cost to the landlord's business and VAT incurred on remedial cladding works to residential property is no different.

The Government stated in its recent Remediation and COVID-19: Building Safety update that the remediation of high-rise buildings with unsafe cladding remains a priority and that employers and their contractors "should consider how best to proceed" whilst lockdown measures remain in place. So in a climate where cash reserves are or may become tight, what can be done to reduce VAT costs?
HMRC's position on zero rating
The general rule is that the supply of construction services to construct new dwellings is zero rated for VAT purposes (i.e. VAT at 0%). This enables the contractor to recover any VAT it incurs in supplying those services and also means that the employer land owner does not, in the main, suffer any VAT costs. In VAT terms, zero is the hero.
So can construction work undertaken now to replace defective cladding be zero rated?
Unfortunately, the answer is not a simple one. This is partly due to HMRC's unclear and shifting guidance on the issue and also the potential for the original circumstances to have altered since the building in question was completed.
In simple terms, at a minimum, for zero rating to apply, the following conditions would need to be satisfied:
  • the original construction work was zero rated with the original cladding (which is now treated as being defective) forming part of the original construction of the building; and
  • the person commissioning the remedial work must have commissioned the original zero rated construction. HMRC have stated this in terms of them having ‘person constructing’ status (a term referred to in the VAT legislation). In the majority of cases, this will mean that the property still needs to be owned by the freeholder/long leaseholder who commissioned the original build.
HMRC have stated that each individual case will need to be looked at separately and, ideally, a clearance sought from HMRC as to the correct VAT treatment to apply. In the current circumstances, when HMRC are likely to be (and understandably) dealing with their own internal pressures taxpayers can probably expect some delays in the clearance process.
There has also been some confusion as to whether the person commissioning the remedial work (the one with person constructing status) is required to engage the same contractor who carried out the original construction.
There have been mixed messages from HMRC on this point but the settled view is that the original contractor does not need to carry out the remedial works i.e. the remedial cladding works can be carried out by other contractors. This is obviously helpful in addressing a practical hurdle to achieving zero rating where, for example, the original contractor is no longer operating, is unavailable or is simply too expensive.
However, circumstances may not always be that straightforward, for example, where a management company is involved or where the remedial cladding works form part of a wider contractual dispute with the original contractor involving other alleged construction defects.

So what are the alternatives if the zero rating conditions are not met and are there any traps or opportunities to be aware of?

Alternatives, opportunities, traps

A possibility is that the remedial work could qualify for the reduced rate of VAT (at 5%) as the installation of energy-saving materials in residential accommodation. HMRC have acknowledged this possibility where the ‘dominant purpose was to improve the thermal efficiency of the building’. However, 'dominant purpose' may be difficult to prove where cladding has been deemed to be faulty and remediation works are for the dominant purpose of making the building safe. Nonetheless, it is something to be borne in mind, since a VAT cost at 5% is more palatable than one at 20%.

Even if a landlord or management company is applying for grant funding to cover the remedial works cost, it is recommended that the application or agreement for funding covers any irrecoverable VAT costs to ensure there is no shortfall. Early engagement with the contractor to understand the anticipated VAT treatment of the remedial works and whether the zero rate or reduced rate can be applied is therefore prudent as this could help to minimise costs and ensure that the grant funding arrangements sufficiently cover anticipated costs, including any VAT costs.

It will also be important to sense check the original contractual supply chain and whether this will need to be replicated to any extent in procuring any remedial cladding work. This will be of particular relevance to corporate groups where a group company was engaged internally (commonly under a framework design and build contract) to procure the original works for the landlord property owning company within the group. Such arrangements are common within the RP sector and may need reviewing in the wider context of cash flows and which entity may be receiving any grant funding.

Whilst the above focusses on standard blocks of flats, it is worth considering the VAT treatment of remedial cladding works to other buildings whose construction was zero rated, such as student accommodation, and whether the zero rate can apply in those scenarios.

Where we can help

Whether you are a contractor supplying remedial cladding work and needing to charge and account for the correct amount of VAT or a landlord or management company procuring such works and seeking to identify VAT costs, agree costings and/or apply for grant funding to meet such costs, it will be important to understand and agree the appropriate VAT rate. Protecting your legal position in the relevant works contracts will also be paramount and also in respect of settling any ongoing contractual disputes involving cladding works.

We can assist with determining the correct VAT treatment of the cladding works, drafting any clearance to HMRC and reviewing and negotiating the terms of the works contracts and any grant funding arrangements. Zero rating of works is achievable where circumstances permit but the devil is in the detail. So please do contact Alexandria Solomou or Nathan Williams to discuss where we can assist.

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