The Chartered Tax Adviser Examination

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1 The Chartered Tax Adviser Examination November 06 Suggested solutions Application and Interaction QUESTION 4 - VAT AND OTHER INDIRECT TAXES

2 Peter Smith A&B Care Ltd First Street AD 4FG Dear Peter Northern Tax Advisers Central Place Anytown AS AB November 06 Acquisition of site for new nursing home We have reviewed the alternative proposals for the acquisition of the site in Grantham. We have set out below the VAT and tax consequences of each route and attached appendices comparing the after tax cost of both routes, based on the estimated value of the completed development. Summary of findings Although the use of a separate development company seems attractive at first glance, on closer scrutiny it is clear that the corporation tax payable on the development profit by the development company will exceed the amount of VAT that would be incurred if you were to purchase the site directly through an operating company. In coming to this conclusion, we have taken account of the fact that no VAT will be payable on the acquisition of the site and, crucially, most of the VAT incurred by your operating company will benefit from the reduced rate of 5%. If A&B Care Ltd buys the site for the nursing home and engages contractors directly, we calculate the VAT and SDLT cost to be 65,750 If a connected development company is used and the nursing home is purchased at a price of 9,000,000, we calculate that the corporation tax, SDLT and irrecoverable VAT payable to be The impact of capital allowance variations on the cost comparison would however be negligible. The use of a development company will also involve set up and financing costs as well as consideration of other commercial risks which are set out below. For the reasons set out above, we do not recommend the use of a separate development company for the care home. VAT will be recoverable in respect of the flats, irrespective of which entity carries out the development. This is because the nature of the first sale to the occupiers is the provision of new housing which is zero-rated. This is discussed below. Development of Nursing Home Value Added Tax implications Direct acquisition and conversion by A&B Care Ltd Acquisition of building Since the seller has exercised an option to tax over the building, in normal circumstances VAT would be payable on any sale. However when an opted property is sold for use as a nursing home following conversion by the purchaser, it is possible for the care home operator to prevent a VAT charge on the sale. () This can be achieved by serving a statutory notice on form VAT 64D on the seller, certifying that the future use of the building will be for a relevant residential purpose as a nursing home. We have enclosed a form VAT 64D for your use. The purpose of this relief is to prevent VAT falling as a cost on the care sector. ()

3 The form must be served on the seller before the price is legally fixed to use the expression which appears in VAT law. This is usually accepted as exchange of contracts but for the avoidance of any doubt, we would advise you to serve the form before signing any agreement. () If the form is served after exchange of contracts but before completion, it will be at the discretion of the seller whether he accepts the form or charges VAT on the sale. You should ensure therefore that your solicitor has a copy of the form and is aware of the requirement to serve it on the seller in good time as part of the purchase documentation. () The reason for the legal requirement for the form to be served before the price is fixed is that by serving the form, the sale of the land will be exempt from VAT. This may have implication for the seller if he has reclaimed VAT on the purchase of the land or any subsequent work in connection with the land. () For example, if the seller purchased the land five years ago and reclaimed VAT of say, 00,000 on the purchase, he will be required to repay 00,000 VAT to HMRC as a result of the exempt sale. The VAT exempt nature of the sale will also make it unlikely that he will be able to reclaim any VAT on the professional costs of the sale. () If the seller incurs additional cost as a result of an exempt sale rather than charging VAT as he intended, he may wish to adjust the sale price to compensate for this or he may wish include a clause in the sale contract requiring the purchaser to indemnify him against any additional VAT cost arising as a result of the exempt sale. Obviously the extent to which A&B Care Ltd may wish to compensate the seller in this regard is a matter for the two parties. () Treatment of deposit The payment of the deposit on exchange of contracts will be treated in the same way as the balance of the purchase price provided form VAT 64D is served on the purchaser before the deposit is received by you. () Conversion of building The conversion work will be subject to VAT. However the reduced 5% rate of VAT applies to work done in the course of the conversion of a building into a nursing home. () The conditions for the 5% rate to apply are. Prior to the conversion work, the building was not used for a relevant residential purpose, for example as a nursing home or residential children s home. This condition is satisfied in your case.. Statutory planning permission has been granted. We assume this will be the case. 3. The services are qualifying services (see below). 4. Before the work commences, A&B Care Ltd provides the contractor with a certificate confirming that the converted building will be used as a nursing home. I have also enclosed a draft certificate for you to complete and sign. Please be aware that A&B Care Ltd is responsible for the accuracy of the information provided to the contractor on the certificate and there are financial penalties for the issue of a false certificate. () Qualifying services covers work done to the fabric of the building in the course of the conversion. It includes repairs and improvements and also any extensions. Materials supplied as part of the conversion services also are eligible for the reduced rate provided they are materials which builders usually install. For example, baths and showers would qualify but fitted bedroom furniture and kitchen appliances are subject to VAT at 0%. () Construction of means of access to the nursing home will also qualify for the reduced rate. () Professional services do not fall within the scope of the reduced rate and will be subject to VAT at the full rate. ()

4 The installation of solar panels will qualify for the reduced rate as part of the conversion. () Once A&B Care Ltd is VAT registered, VAT will be payable on the sale of electricity to the grid. The export tariff agreement will almost certainly provide for this. An incidental benefit of this is that you may be able to reclaim a small amount of the VAT paid on the installation of the solar panels. The panels will serve two purposes; power for the care home which provides VAT exempt care services and power into the grid which is subject to VAT. The method of calculating the proportion of VAT which can be reclaimed on purchases which provide exempt services and also services which are subject to VAT is a complicated area and beyond the scope of this report. Broadly however you may be able to reclaim a proportion of the VAT incurred on the solar panels which corresponds to the value of electricity supplied to the grid as a percentage of your total turnover. Alternatively you may be able to arrange a special agreement with HMRC whereby you calculate the percentage based on the use of the output of the panels. We have assumed the latter for the purpose of our calculations but in any event the amount of reclaimable VAT will not be significant in the context of the comparison of the methods of acquisition. () Development by a connected development company A&B Care Ltd will have to set up a new wholly owned subsidiary which will be required to register for VAT with the intention of making a zero-rated sale of a building to be used as a nursing home, converted from a building which has not been used for a residential purpose, HMRC will want to see evidence of the company s intention, for example, planning permission and contracts. This must be a separate VAT registration from A&B Care Ltd. () Acquisition of building It will still be possible for the development company to prevent the VAT charge on the deposit and purchase price of the building since form VAT64D can also be issued by a person converting a non-residential building for use by a third person as a nursing home. This may increase the seller s VAT cost. Any VAT would be recoverable by the development company in any case but the use of the certificate will reduce the SDLT cost since this will be applied to the price without any VAT and improve cash flow. () Conversion of building Provided A&B Care Ltd produces a certificate to the development company confirming that the converted building will be used as a residential nursing home, before the transfer of the property to A&B Care Ltd, the sale to A&B Care Ltd will be zero-rated. The certificate is slightly different from the certificate to obtain conversion services at the reduced rate mentioned in the previous section and I have enclosed a form of the certificate for your use. () Since the sale to A&B Care Ltd will be zero-rated, VAT will be recoverable by the development company on both goods and services used in the conversion work. However the contractors will have to charge the full rate of VAT on their services rather than the reduced rate. This is because the development company will not be using the nursing home and therefore cannot give a certificate of use to the contractors. () Since the development company can recover this VAT, there is no tax cost other than in terms of cash flow. Even this can be minimized if the development company elect for monthly VAT returns. Provided the redevelopment is carried out under a design and build contract, under which the development company instructs the professional services, VAT on professional services will be recoverable by the development company. () VAT will be not recoverable by the development company on the cost of bedroom furniture and kitchen appliances but presumably this will be included in the price of the onward sale to A&B Care Ltd. () 3

5 The provision of administration and other staff from A&B Care Ltd to the development company will in principle be subject to VAT since A&B Care Ltd will be registered for VAT in respect of the sale of the flats. You are correct that it might be possible to avoid a VAT charge if the employees were jointly employed by both companies. However this would involve a change to their employment contracts and would effectively give them two sets of employment and pension rights etc. Since any VAT charged will be recoverable by the development company, it seems unnecessary to use joint contracts of employment. You could simply register for VAT and recharge for the staff time, with VAT. This will also assist the overhead VAT recovery in A&B Care Ltd. Consideration should also be given to recharging for management and other admin time. () The provision of office space from A&B Care Ltd to the development company would be exempt from VAT. It would be possible for A&B Care Ltd to opt to charge VAT on the rent. This VAT would be recoverable by the development company but since VAT on the building cost will be recovered by the development company, there is no advantage for A&B Care Ltd in opting to charge VAT. () Transfer of nursing home to A&B Care Ltd As noted, the transfer of the building will be zero-rated. Is there any VAT avoidance under this arrangement? There is a legal requirement to notify any VAT avoidance arrangements to HMRC. If there were a duty to disclose these arrangements, in certain circumstances, there are penalties for failure to disclose to HMRC schemes which produce a tax advantage. () HMRC have published a list of notifiable schemes and indeed the first scheme on the list involves the zero-rated sale of a major interest in a building to a connected party. Since A&B Care Ltd would own the development, the companies will be connected for these purposes. () However a tax advantage is considered to occur only if the arrangements result in recovery of VAT on future maintenance or refurbishment of the building. That element is not present in these arrangements but crucially zero-rating arising following the conversion of a non-residential building is specifically excluded from the listed schemes. However if this arrangement were to be implemented, it would be prudent to make a protective disclosure of the arrangements to HMRC. () Corporation tax The trading profit which the development company makes on the development on the resale of the property will be subject to corporation tax at 0%. () The intercompany recharges can be ignored for the purposes of the comparison as extra tax in one company on the receipt will be matched by less tax in the other on the expense (See appendix C). () If the nursing home is sold for less than market value, the profit immediately taxed in the development company would be reduced (as would be the base cost on a future sale of the property). However, provisions exist (the transfer pricing rules) to prevent transactions between connected parties at less than market value. There is an exemption for small and medium sized companies which may apply here. Whatever the consideration, () Some measure of tax relief will be available to A&B Care Ltd in respect of plant and machinery in the converted nursing home. The final amount will depend on the extent of any other capital expenditure made by A&B Care Ltd in the accounting period which could use some or all of the annual investment allowance (see below). () Capital allowances for the building are only available in respect of plant and machinery. Structural works such as creating the bathrooms, unless directly related to the installation of plant will not qualify for capital allowances at all. Some plant will qualify for an annual writing down allowance of 8%. 4

6 Other plant, (known as integral features) will attract a reduced special rate of 8%. Whilst fire alarms qualify as plant and machinery, fire doors will not qualify for capital allowances as they are considered to be part of the structure. Legislation provides that heating, lighting and lifts are treated as integral features. () As mentioned above, depending on other expenditure, part of the 00,000 annual investment allowance may be available and this would be claimed in priority against integral features which benefit from the lower rate of capital allowances. () A similar level of allowances will be available to A&B Care Ltd if the development is carried out through a separate development company, although in this case the amounts will be based on the cost to the development company net of recoverable VAT. Overall, the difference is small and this will not affect the decision as to which route to follow. () Appendix B sets out the expenditure which will qualify for capital allowances at 8% and at 8% and also shows how the annual investment allowance should be allocated to maximise the tax relief in the year of the expenditure. It may be also that a detailed review would reveal other items eligible for a capital allowance claim. SDLT Stamp Duty Land Tax of will be payable on the purchase of the building, on the assumption that VAT is not charged. This is based on the purchases being linked transactions and attracting a SDLT rate of 4%.,500,000 X 4% = There will also be no SDLT to pay on the sale since the development company is wholly owned by A&B Care Ltd and the transfer of the property will fall within the SDLT relief which applies to transaction between companies under 75% or more common control. () Climate Change Levy () In principle the supply of electricity is subject to climate change levy. Until August 05 there was an exemption from climate change levy for energy produced from renewable sources, but this relief has now been withdrawn. () The sale of electricity to the grid, known as the generation tariff will not be subject to climate change levy since it is a wholesale supply of electricity and not a supply of electricity to a business consumer. () Self-supplies of electricity can sometimes be subject to climate change levy. However supplies to a care home are treated as domestic supplies of electricity and therefore are excluded from the climate levy. Other issues A&B Care Ltd will have to set up a new wholly owned subsidiary with appropriate articles to allow it to carry out the development. The company must be registered at Companies House and you must also notify HMRC. This should be a relatively inexpensive process. () The new company will require finance to undertake the development. We assume A&B Care Ltd will obtain loan finance from a financial institution and provide finance to the development company for 5

7 each stage of the development. Interest paid on the funds borrowed by A&B Care Ltd will be deductible for tax purposes under either route. () There will be other issues to consider when setting up a separate development company, particularly in terms of liability. If a defect emerges in the building work, A&B Care Ltd s first recourse would generally be against the development company which then would have to bring an action against the responsible contractor. However A&B Care Ltd could set up collateral warranties so that it could take direct action against the contractor. The development company will need to arrange adequate insurance in this area. () You would also need to consider the appointment of advisers to the new company. Provided the new company is a 00% owned subsidiary of A&B Care Ltd, it is likely that there would be sufficient mutuality of interest between the two companies for us to act as advisers. We would need to extend the terms of our engagement to include the new company. () Development of assisted living units Value Added Tax implications Acquisition of the adjoining land Unfortunately the scope of the relief from VAT using Form 64D which is explained above is restricted to buildings and will not apply to the adjoining land since it is not part of the curtilage of the building. VAT will remain payable on the sale of the land therefore with no consequences for the seller. It may be possible to approach the seller to invite him to consider whether he would revoke the option to charge VAT, which may be possible if the option was exercised more than 0 years ago. () Construction and sale of Assisted Living Units The VAT treatment of the flats is a difficult area of VAT with the treatment depending on whether for VAT purposes the flats can be considered to be separate dwellings or whether they are part of the nursing home. In the former case, the sale of the flats will be zero-rated allowing some element of recovery of VAT on development costs whereas in the latter case VAT will be payable on the development in the same way as the nursing home. () In order for the flats to qualify for zero-rating, broadly two conditions need to be satisfied. A major interest in the flats must be sold by the person who constructed them and the flats must satisfy the VAT rules on dwellings. These points are considered further in the following paragraphs. () A major interest means the sale of a freehold or the grant of a lease for a period exceeding years. Under a shared ownership arrangement, the occupier purchases the property at a proportion of its value but also makes rental payments in connection with his occupation the property. In future the occupier can make further payments to increase his share of the equity in the property. The sale of the first tranche of equity is regarded as zero-rated although subsequent payments or rent and purchase of increased equity are exempt. As a result of this treatment, HMRC allow the developer to recover VAT on development costs in full provided the other conditions of zero-rating are also met. () The person who constructed them does not mean physical construction. A developer who has commissioned the development is regarded as the person who has constructed the flats. A&B Care Ltd will qualify under this head. () We then come to the most difficult part, whether the flats qualify as dwellings. For VAT purposes, a house or flat qualifies as a dwelling when the following conditions are satisfied: ) the dwelling consists of self-contained living accommodation ) there is no provision for direct internal access from the dwelling to any other dwelling or part of a dwelling 3) the separate use or disposal of the dwelling is not prohibited by the terms of any covenant, statutory planning consent or similar provision and 6

8 4) statutory planning consent has been granted in respect of that dwelling and its construction or conversion has been carried out in accordance with that consent. () There are no issues with the requirement for the flats to be self-contained or with no internal access to any other flat. Similarly HMRC no longer regard the class of planning permission as decisive, so it will not be an issue if the flats have been constructed under the same class of planning permission as the nursing home provided they meet the other conditions for dwellings. () The question of separate use or disposal needs careful consideration. The fact that the flats are designed for a particular class of persons i.e. people in later life is not decisive. An occupation restriction is not a restriction on use or disposal in this context. (U8)The purchase of a care package is not a requirement and if purchased at a later stage would comprise a separate supply of exempt care services. Decisively the occupier can sell this flat to another person. In the circumstances where there is no restriction on separate use or disposal, the flats qualify as dwellings for VAT purposes and zero-rating will apply to construction costs and the initial sale of an equity interest to the occupier. No certification is required for dwellings. () Since the sale of the first equity share to the occupier will be zero-rated, A&B Care Ltd will be able to reclaim VAT on the land and professional costs of the assisted living units. There will be no VAT payable on construction costs and materials supplied together with the construction services. VAT will not be recoverable on the bedroom furniture and kitchen appliances but I expect this will be included in the sales price to the occupiers. The annual service charge for the residential units will be exempt from VAT but this will have no impact on the recovery of VAT on the construction costs. () In order to achieve a reclaim of VAT, A&B Care Ltd will have to register for VAT. This can be done by an on-line application although it is likely that HMRC will require some evidence of the intended sales, for example a copy of the planning permission or marketing information. Once registered, A&B Care Ltd can reclaim VAT on these items through its VAT return. This is usually submitted on a quarterly basis but since A&B Care Ltd will receive repayments of VAT, it should request that it submits returns on a monthly basis to assist its cash flow. () VAT invoices will be required from the suppliers in relation to the land and professional fees showing the amount of VAT at 0% which has been charged. () Once A&B Care Ltd has sold an equity share in all the flats, it will have to cancel its VAT registration since its future sales will be exempt from VAT, unless you wish to remain registered in respect of supplies of electricity to the grid. There is however unlikely to be any tangible benefits resulting from remaining registered for VAT. () SDLT Stamp Duty Land Tax of 4,000 will be payable in the purchase of the land. Since SDLT is based on the VAT inclusive value, the higher rate of 4% applies. () If you would like to discuss this further, please do contact us. Fred Brown 7

9 Appendix A Calculation of tax cost of development by direct purchase by A&B Care Ltd Irrecoverable VAT Professional fees 8,000 Conversion work (5% VAT charged) 6,750 Kitchen ovens & fridges 8,000 Fitted bedroom furniture 5,000 Solar panels (80%)* 8,000 Total 65,750 *Assuming 0% recoverable by reference to taxable sale of electricity to grid (4) Summary of tax cost of direct development SDLT 00,000 Irrecoverable VAT 65,750 65,750 Appendix B () Schedule of potential capital allowances (including irrecoverable VAT) Items of plant AIA 8% 8% Solar panels 00,000 8,000* Plumbing & heating 36,50 Lighting 78,750 Baths, showers, toilets etc 05,000 Fire alarms,00 Ovens and fridges 48,000 Bedroom furniture 50,000 Lift 05,000 00,000 39,00 48,000 Total allowances in year 93,496 00,000 59,56 (8%) 34,40 (8%) *(Assuming 0% of VAT reclaimable by reference to sales of electricity to grid) (5) 8

10 Appendix C Calculation of additional corporation tax payable by a new development company Sale proceeds 9,000,000 Costs (excluding VAT) Building (including SDLT),600,000 Conversion cost,740,000 Irrecoverable VAT on ovens/fridges/bedroom furniture 6,000 5,366,000 Net profit 3,634,000 CT 0% 76,800 (3) Summary of tax cost of conversion by development company SDLT Irrecoverable VAT 6,000 Additional corporation tax payable 76,800 85,800 () 9

11 MARKING GUIDE TOPIC Requirement Development of Nursing Home VAT Acquisition of building Relief for residential purpose Service of VAT 64D to claim exemption Timing before price legally fixed Service before completion Implications for seller Example of clawback Indemnity for purchaser MARKS 7 Deposit Exempt if VAT 64D served prior to payment Conversion 5% rate Conditions for reduced rate Builder s materials. VAT at 0% on bedroom furniture & appliances Means of access qualify for 5% Professional services subject to 0% Solar panels qualify for 5% rate Feed-in tariff is outside the scope, export tariff potentially subject to VAT 9 Set-up of development company VAT registration Acquisition of building VAT relief also available for converter Conversion of building Zero-rated sale provided certificate provided VAT on costs recoverable including goods. Contractors will charge VAT at 0%.Cash flow. VAT not recoverable on furniture & appliances and payable by A&B Care Ltd in price. Use of design & build contract. Supply of Staff. Use of joint contracts. Employment rights. VAT recoverable if charged. Use of office exempt. No advantage from OTT. 5 Consideration of avoidance Connected parties but conversions excluded from listed schemes. 3 Corporation tax Payable on development profit at 0% Recharge of staff costs and rents tax neutral Valuation of sale between connected parties 4 0

12 Capital allowances Available on plant Rates of 8% and 8% Annual investment allowance Not significant in decision SDLT SDLT on purchase of building No SDLT on transfer from development company as group relief Climate change levy No charge on wholesale supplies Self-supply excluded Other Issues Set-up of development company Companies House/HMRC notification Loan finance Liability for defects. Insurance Engagement Appendix A Calculation of tax cost for direct purchase of nursing home Appendix B Capital allowances Appendix C Calculation of tax cost of use of development company Total for Requirement 6 Requirement Assisted living units Acquisition of land Subject to VAT SDLT on total Construction and sale of assisted living units VAT treatment depends on whether dwellings Zero-rating for sale of major interest in dwellings by person constructing them First sale of equity under shared ownership qualifies Person constructing Definition of dwelling Class of planning not decisive Capable of separate use & disposal. No certification required. Recovery of VAT relating to zero-rated sale Registration as intending trader. Monthly returns Requirement for tax invoices. Cancellation of registration when first sale of equity in flats completed 4 Total for Requirement 6 78 Presentation and Higher Skills TOTAL 00