VAT treatment of cladding works – zero is the hero
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 replacing cladding on residential property is no different.
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 – but can construction work undertaken now to replace defective cladding be zero rated?
The answer is not simple, partly due to HMRC's shifting guidance on the issue and also, the potential for the original circumstances to have altered since the building in question was completed.
HMRC has not published clear guidance but, in our experience, HMRC’s view is that all of the following conditions need to be satisfied for zero rating to apply:
- the original construction or conversion of the building was zero rated;
- the cladding being replaced was included on the original plans and formed part of the construction of the building;
- the property is still owned by the person who commissioned the zero-rated construction or conversion of the building (i.e. the developer or freeholder);
- the cladding is unsafe and is therefore being replaced to correct a fault;
- the property developer or freeholder (i.e. the person who originally commissioned the zero-rated construction or conversion) organises the replacement of the cladding (e.g. by appointing a contractor); and
- the cladding is replaced as soon as possible.
Given the lack of published guidance from HMRC, we recommend that a clearance is obtained from HMRC that the work is zero-rated in order to provide certainty. In our experience, this is fairly straightforward if the above conditions are met. Of course, HMRC would expect the landlord to be able to demonstrate that the conditions are met if asked by HMRC. For example, documentation confirming that replacement of the cladding is being undertaken on the advice of suitably qualified professionals.
There has been some confusion as to whether the person commissioning the cladding replacement is required to engage the same contractor who carried out the original construction. The settled view now is that the original contractor does not need to carry out the works. This is helpful in addressing a practical hurdle to achieving zero rating where, for example, the original contractor is no longer operating, unavailable or too expensive.
However, circumstances may not always be straightforward, for example, where a management company is involved or where the cladding works form part of a wider contractual dispute with the original contractor involving other alleged construction defects. Are there any alternatives if the zero rating conditions are not met and are there any traps to be aware of?
Alternatives, opportunities and traps
The 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 is 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 the works are for the dominant purpose of making the building safe.
Even if a landlord or management company is applying for grant funding to cover the cost of the work, 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 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 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 housing association 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 cladding works to other buildings whose construction was zero rated, such as student accommodation, and whether the zero rate can apply in those scenarios.
Whether you are a contractor supplying 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 the VAT treatment of the proposed work. Zero rating of works is achievable where circumstances permit but the devil is in the detail.