We are responding to HMRC s proposed changes to Public Notice 708 and the internal guidance relating to design and build contracts.

Steve Lumby VAT Liability Team VAT Directorate 100 Parliament Street London SW1A 2BO 1 July 2011 Notice 708 Design & Build Amendments Dear Steve, We are responding to HMRC s proposed changes to Public Notice 708 and the internal guidance relating to design and build contracts. We understand that HMRC believe they are compelled to make this amendment in light of the decision of the European Court of Justice in the case Talacre Beach Caravan Sales Ltd v HMRC (C-251/05; [2006] STC 1671.) ( Talacre ). Lion Court 25 Procter Street London WC1V 6NY Tel: 020 7067 1010 Fax: 020 7067 1011 Email: info@housing.org.uk Website: www.housing.org.uk In the attached document we have set out our thoughts on: The application of Talacre to design and build contracts and set out why we believe the case can be distinguished and the current VAT treatment maintained; The effect that the proposed amendment could have as drafted (on social housing) and What, if the amendment is implemented, we believe is necessary to manage the impact of this change. Given the potential impact the proposed amendment could have on the social housing sector we would be very keen to meet with you and our technical advisors KPMG to discuss this matter. Once you have had a chance to read this letter we will be in contact to arrange a meeting. Yours sincerely John Butler Finance Policy Officer T: 0207 067 1177 Email: john.butler@housing.org.uk Registered office: Lion Court, 25 Procter Street London WC1V 6NY 1 A company with limited liability Registered in England No. 302132

Notice 708 Design & Build Amendments VAT Technical Considerations and Comment The National Housing Federation The National Housing Federation represents 1,200 independent, not-for-profit housing providers in England. Our members include housing associations, co-ops, housing trusts and local authority transfer organisations. They develop and manage 2.5 million homes provided for affordable rent, supported housing and low-cost home ownership housing for over 5 million people, as well as delivering a wide-range of community and regeneration services. The role of housing associations extends far beyond the buildings they build, own and manage. The work they do contributes directly to the creation and maintenance of successful, sustainable neighbourhoods and communities which provide improved quality of life, increased opportunities and improved social mobility for their residents - delivering prosperity to many of the least well off in society. Government acknowledges the vital role housing associations play in achieving its objective of over 150,000 new homes between 2011 and 2015. As a result of the Comprehensive Spending Review, Government's new investment framework for the housing association sector will result in a 63% reduction in capital grant funding of new affordable homes between 2011 and 2015. This unprecedented reduction coupled with significant changes to the planning system and new housing benefit cutbacks will create huge financial and operational hurdles for the sector. A change in the VAT treatment would add further financial difficulty and would ultimately impact the number of new affordable homes that are delivered by Housing Associations. Effect of the proposed amendment for housing associations VAT incurred by a housing association in respect of rented social housing represents a cost to the housing association. The majority of a housing association s housing development projects are delivered through design and build contracts. Therefore, if HMRC s proposed change is implemented such that VAT applies to the deemed design element of any design and build contract, this will result in significant additional cost implications for the social housing sector. As has been well publicised in the press there are increasing pressures to deliver new social housing (the Government has expressed a desire for 150,000 new affordable homes over the next 4 years) in an economic climate which sees restrictions on both grant funding and the availability of third party funding. Consequently, housing associations are very cost sensitive, and any increase in costs potentially puts at risk new housing developments. The Homes and Communities Agency ( HCA ) has put together the framework for the 2011-2015 Affordable Homes Programme ( AHP ) which details how the 150,000 new homes are to be delivered and how the funding requirements will apply over the next four years. Housing associations have submitted bids to develop under the new AHP and the expectation will be that contracts with the HCA will be signed before the VAT changes come into effect. The proposals that are being put together will not have budgeted for this change in policy on design and build which will result in fewer houses will be built for social housing rent. 1

The main aspects of the AHP which have commercial impacts for the housing associations are as follows: The amount of grant received will be significantly less than under the current framework The timing of the grant will be at completion and will be on a payment by results basis (i.e. the housing associations will have to fund the developments entirely until completion) The housing associations are expected to increase financial capacity by converting social let property to Affordable Rent (where rents of up to 80% of gross market rents can be charged) and The housing associations will be expected to deliver the homes over a period of 4 years. Under the new model, much less of the funding is provided through grant funding. Instead, the housing associations are expected to be able to obtain increased funding through third party sources, from the increased rental stream, from the conversion of existing property to Affordable Rent and from new Affordable Rent property. As well as the difficulty in sourcing debt from the financial sector, this model is directly affected by the Government s welfare reform plans. Any restriction in the payment of benefits will have a knock-on effect on the amount received through social housing rent. Regardless of the potential for increased income through Affordable Rents, there will be instances where defaults are commonplace. All of this means that over the four-year period of the operation of the AHP, housing associations will be tightly constrained on costs and will require certainty over the tax aspects of those costs during that period. A change to the interpretation of the current VAT treatment of design and build contracts in addition to having a financial impact may also have negative social impact. This is in our view entirely the opposite of what is intended to happen. To put the above into context the Federation has prepared some initial calculations on the impact of the change for the 150,000 new homes to be delivered under the AHP. The results show that the change will create an increase in funding required of 108 million. This equates to more than 2,600 homes that could not be delivered if funding for this additional cost cannot be sought from elsewhere. However, the true cost of the housing shortfall is likely to be significantly higher. This is because any cash shortfall will not result in the adjustment (reduction) of housing in a development but will jeopardise the entire development. We consider this to be a delicate issue for housing associations and one that potentially has wide ranging political and social implications. Having considered both the AGO opinion and ECJ decision, we believe there is a basis on which Talacre can be distinguished and the current VAT treatment maintained. The amendment to design and build contracts The amendment to paragraph 3.4.1 is reproduced in Appendix A Should the amendment be adopted, building contractors would be required to account for VAT on any design element of a design & build contract. 2

Application of Talacre The decision in Talacre states that the fact that specific goods are counted as a single supply, including both a principal item which is by virtue of a member state s legislation subject to an exemption with refund.. and items which that legislation excludes from the scope of that exemption, does not prevent the member state concerned from levying VAT at the standard rate on the supply of those excluded items. In this decision the ECJ indicates that VAT can be applied to a proportion of a single supply, where the following applies: (i) The supply is zero-rated for UK VAT purposes (ii) The zero-rate is one that applies due to the transition reliefs under what was article 28(2)(a) of the Sixth Directive (now articles 110 112 of the EU VAT Directive 2006/112/EC) (iii) There is and was a legislative restriction limiting the scope of the zero-rating on 1 January 1991 or subsequently introduced and (iv) Effectively charging two rates of VAT for a single supply does not lead to insurmountable difficulties capable of affecting the proper working of the VAT system. Our conclusions as to the whether the above points apply in the case of zero-rated construction services are as follows: (i) The supply is zero-rated for UK VAT purposes (ii) The zero-rated provisions under VAT Act 1994, Schedule 5, Group 8, item 2 are covered by art 28(2)(a) of the Sixth Directive (iii) A legislative restriction exists covering the supply of architects, surveyors or any person acting as a consultant or in a supervisory capacity and (iv) It is unlikely that accounting for VAT would be insurmountably difficult. Therefore, from our analysis of the case, we believe that there is an argument that Talacre has direct relevance to the zero-rating under VAT Act 1994, Schedule 5, Group 8, item 2. On this basis, it would appear that Talacre supports the position of VAT being accountable on architects, surveyors, consultants or a person acting in a supervisory capacity even when provided under a single supply. However, we do not agree that the application of the Talacre decision results in the changes to design and build that HMRC are proposing. Our reasons are explained in the two subsections below. 1 The nature of the service The purpose of the restrictions with regard to residential caravans, as explored in Talacre, is clearly to prevent zero-rate applying to goods that are commonly supplied, in an unchanged form, as part of a single transaction. The restrictions with regard to new build on the other hand, are concerned with the supplies of services made separately in the course of the construction of a new dwelling for instance, plumbers, carpenters, 3

bricklayers and architects all supply services individually in the course of a construction, either to the land owner or to a main contractor. The effect of the restrictions is to render the services of the architect subject to VAT, whilst the others qualify for zero-rating. However, this only applies when the services are supplied or re-supplied in an unchanged form. Where these services are consumed in providing the services, there is no re-supply and hence no restriction should apply. For example, a main contractor that acquires all of those services, may use them to provide a further, different, more complex supply to a developer the construction of a building. In doing this it will have absorbed those individual elements as cost components of its supply and in the process of this absorption the elements will have changed and lost their identities. As such it will no longer be possible to say that, within the construction, there is a supply of architect s services (to take the one standard-rated cost component) that can be identified, separated and treated as a standard-rated portion of the overall charge. To do so is illogical the contractor is not an architect and the purchaser is not buying an architectural service; it is buying a finished property. HMRC would not expect the builder to strip out supplies of excluded services for a pure build contract where they are consumed by the builder for the purposes of delivering the building even though they are undoubtedly an element consumed by the builder during the construction process. This is clearly illustrated in respect of the hire of goods (another exclusion from zero-rating under VAT Act 1994, Schedule 8, Group 5, Note 20) used in the construction of dwellings. A building contractor will often hire goods in order to complete the construction of a building. While the lease of goods is excluded from the zero-rate, the contractor is not required to strip out the cost of its hire of goods and account for VAT on that item. This is because it is consumed in the overall building supply by the contractor and is not resupplied on in an unchanged form. This contrasts completely with the situation of the caravan sold with its contents. In that case there is undoubtedly (even if there is a single supply, with a single consideration) a clear, distinguishable portion comprising the contents that cannot be seen to have been absorbed or changed by its amalgamation into the overall supply of the caravan. From this it is clear that Talacre addresses an entirely different situation to the one to be addressed with design and build where the cost components of the final supply are not onward charged in an unchanged form. By way of a final example to illustrate our point, house builders are often required to build a number of dwellings as part of the planning permission (under Section 106 agreements). It is understood that in a typical scenario the house builder will sell the land to a housing association and then construct the dwellings to the housing association s specifications. These will include size and number of rooms, door width, flooring and sustainability level, etc. The house builder will usually build the social houses so that they are in keeping with the rest of the estate being built. Under HMRC s proposed amendment, where the build is carried out under a design and build contract, the house builder would have to strip out an element of design. However, as there is no re-supply of design being provided (merely building to specification) we do not consider there to be any elements on which VAT would apply. 4

2 Purpose We note that HMRC s current treatment for design and build was in existence on and before 1 January 1991. This can be demonstrated from the both the wording in the VAT Act 1983, Schedule 5, Group 8, Item 2 and section 11 of Public Notice 708/2/90 (see Annex B). It may be assumed that the legislation in conjunction with the guidance in the Public Notice demonstrated the intended scope of the legislation by Parliament as of 1 January 1991. If this were the case, it is arguable that no amendment need be made as the purpose and practical application of the legislation since before 1991 allowed zero-rating for design and build (i.e. the scope of the zero-rating has not changed). While we accept that the decision in Talacre only refers to the legislative restrictions, it should be appreciated that the practical scope was wider than this. It is also relevant to note that maintaining the current VAT treatment would preserve the original defined social reasons and the zero rating would continue to be for the benefit of the final consumer. This can be distinguished from the position in Talacre where the zero rating of the goods would have breached these conditions. Wording of the amendment and its application After the reasons detailed in the 2 subsections above and further discussion HMRC may still require amendment to the guidance. If this were the case then while HMRC is potentially required to make reference to the application of Talacre in its guidance, the proposed amendment, as currently drafted, to design and build does not accurately achieve this. The proposed amendment is too broad in its drafting and we have significant concerns it leaves too large a scope for interpretation. We consider that the Public Notice needs to be very clear on those services covered by the legislative exclusion (and therefore not covered by the zero-rate) and also be clear where it applies. Were HMRC to wish to comment in Public Guidance on the effect of Talacre it could replace the section on design and build with one that clearly defined the scope of design. This would confirm the scope of Talacre without incorrectly broadening it. Effect of the proposed amendment As stated above, if HMRC continue with their proposed amendment and it is interpreted (incorrectly as we have argued) as affecting all design and build contracts, this will result in additional VAT being payable on construction contracts for dwellings, relevant residential and relevant charitable buildings. Furthermore, additional VAT would arise in respect of non-residential to residential conversions for relevant Housing Associations. While, a proportion of these types of contract will only have a cash-flow impact, there are a number of businesses where this will not be the case. The Federation and its members have identified this change as resulting in a significant cost to this sector with potentially detrimental effects on the building of new social housing. 5

Transitional period As we have argued above, we do not consider that Talacre has the effect that HMRC are proposing. However, if the amendment is implemented as proposed, one way of managing the impact of this change for housing associations is to introduce a transitional period. Housing associations are entering into contracts with the HCA in July on the basis of the current policy on design and build. As such, the current treatment will need be applicable to all developments provided under the AHP (which is a four year programme). Therefore, we would suggest transitional rules which would allow the current design and build treatment to apply where any of the following take place within 12 months of the change: (i) Where agreements have been entered into with HCA or GLA (Greater London Authority, as will be the case for London developments) for the construction of social housing under the AHP; or (ii) Where written applications have been made for funding or (iii) Where building contracts have been entered into or (iv) Where building works have commenced or (v) Where payments have been made or invoices issued in respect of building contracts. Such transitional basis would allow housing associations to carry out developments for the period of the AHP on the basis of the current treatment. It should be possible for the housing associations to certify to builders that the works to be carried out are subject to agreement with the HCA or GLA under the AHP if HMRC require. It is within HMRC s powers to grant a transitional period for non-statutory changes as evidenced in Revenue & Customs Brief 39/09 where a transitional period was granted for the change in interpretation of the term solely. In that instance a 12 month transitional period was applied. That transitional period allowed charities to use a withdrawn extra statutory concession provided that construction had commenced (where a building was to be constructed) or a deposit paid (where a property was to be purchased) before the end of the transitional period. 6

Appendix A Design and build: Here the building client engages a contractor to carry out both the design and construction elements of the project. Where the design, workmanship and materials are supplied under a design and build lump sum contract, the VAT liability of the design element will follow that of the building work. This also applies where the part of the sum for the design element is shown separately solely for internal analysis purposes. But separate supplies of design or other similar professional services are always standard-rated; becomes Design and build: Here the building client engages a contractor to carry out both the design and construction elements of the project. Where the design, workmanship and materials are supplied under a design and build lump sum contract, the VAT liability of the design element will be standard-rated 7

Appendix B VAT Act 1983, Schedule 5, Group 8 Construction of Buildings etc Item No. 1. The granting by a person constructing a building of a major interest in, or in any part of, the building or its site. 2. The supply (a) in the course of the construction, alteration or demolition of, or (b) in the course of the installation of any glazing to provide double or other multiple glazing for the first time in a particular location in, any building or any civil engineering work, of any services other than the services of an architect, surveyor or any person acting as consultant or in a supervisory capacity. 3. The supply, by a person supplying services within item 2 and in connection with those services, of (a) materials or of builder's hardware, sanitary ware or other articles of a kind ordinarily installed by builders as fixtures; or (b) in respect of such goods, services described in paragraph 1(1) of Schedule 2 to this Act. Notes : (1) Where the benefit of the consideration for the grant of a major interest as described in item 1 accrues to the person constructing the building but that person is not the grantor, he shall for the purposes of that item be treated as the person making the giant. (2) Item 2 does not include (a) any work of repair or maintenance ; or (b) the supply of any services in the course of the construction or alteration of any civil engineering work within the grounds or garden of a building used or to be used wholly or mainly as a private residence ; or 8

(c) the supply by a person of any services which consist of or include any services supplied to him by some other person otherwise than in the course or furtherance of any business carried on by that other person ; or (d) the supply of services described in paragraph 1(1) or 5(3) of Schedule 2 to this Act. (3) Section 16(3) of this Act does not apply to goods forming part of a description of supply in this Group Extract from Notice 708/2/90, Part IV Building Contracts, Section 11 A client may obtain the necessary design work for a building project from a contractor as part of a Design and Build package deal with the contractor. Where the design, workmanship and materials are supplied by a contractor to his client under a Design and Build lump sum contract without any separate identification of the part of the lump sum relating to the design element, the VAT liability of the design element will follow that of the building work. For example, where a new building project is concerned, if the building works supplied by the contractor are zero-rated the design is also zero-rated. This also applies where, within a lump sum design and build contract, the part of the sum for the design element is shown separately solely for internal analysis purposes by the two contracting parties. But if there is a separate supply of design or other similar professional services to a client, it is always standard-rated. 9