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Sale and leasebacks and the VAT ‘change of use’ rules

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Those involved in the development of or investment in care homes, student accommodation and other institutional living space will likely be familiar with the VAT concept of ‘relevant residential purpose’ (RRP) in VATA 1994 Sch 8 Group 5 note 4 and some of the VAT conundrums that come with it. None perhaps can give such perverse results as the ‘change of use’ rules in VATA 1994 Sch 10 para 36. The recent decision of the Scottish Court of Session in Balhousie Holdings Ltd v HMRC [2019] CSIH 7 illustrates this.

Where a person ('P') pays for the development or acquisition of a new RRP building, the supply is typically at the zero rate of VAT under VATA 1994 Sch 8 Group 5. The benefit to the supplier is that this allows recovery of associated input VAT. Under VATA 1994 Sch 10 para 36, if the building ceases to be used for an RRP within ten years, under the change of use rules P may suffer a VAT charge based on the VAT it saved by virtue of the original zero rating (though this unwinds over the period to reflect the amount of ‘good’ use). Since para 36 was substituted by SI 2011/86 in 2011, however, ‘change of use’ has been a misleading description. The charge also applies if P merely disposes of their ‘entire interest’ in the property during the same period. 

The taxpayer in Balhousie owned and operated a number of care homes. A member of the corporate group that had made a zero-rated acquisition of one home entered into (as a form of financing) a sale and 30-year leaseback transaction with a third party, under which the seller/tenant company was then obliged to continue operating the property as a care home.

HMRC claimed that despite the leaseback immediately following it, the sale meant the seller/tenant company had disposed of its ‘entire interest’, and therefore the VAT charge applied. The court agreed, characterising VAT as a tax dependent on objective analysis of each individual transaction. It was therefore not correct to say (as has been held in the direct tax world in, for example, Sargaison (Insp of Taxes) v Roberts (1966–69) 45 TC 612) that a sale and leaseback is merely a part disposal. 

You might wonder what policy requires the rules to operate in this way. Shouldn’t it help that there was demonstrably no actual change of use, since despite the ‘disposal’ the property had remained in possession of the same care home operator? Unfortunately not. The ‘disposal of entire interest’ rule clearly operates independently from the need for any change of use. However the court’s unwillingness to characterise this transaction as something other than an outright disposal seems to have been founded on its support for the purported policy of the rule.

The idea (as HMRC said, and the court effectively adopted) is to avoid a situation where P sells the property and so loses control over the subsequent use, but remains liable for an (actual) change of use charge. That this is a sensible reason for instead imposing an automatic charge on the disposal itself (irrespective of whether there is a subsequent change of use) only has to be stated to invite the John McEnroe response.

The real policy here is, of course, that the development of and capital investment in this kind of accommodation should not create a real VAT cost for those involved in it, or for its users. That's what the zero rating is for. If you rely on that regime and then turn the premises to uses outside that policy, it makes sense that you can suffer a ‘clawback’ of the benefit. If you rely on that regime and use the property only for an RRP purpose but still suffer irrecoverable VAT on sale, then investors, and any care home residents seeing concomitant rises in fees, could be forgiven for thinking the policy pretty ill-served.

Incidentally, the CJEU has now taken a different approach to a situation of this kind in giving its decision in Mydibel SA v État Belge (Case C-201/18). This Belgian case also concerned a sale and leaseback financing by an occupier. The question was, in part, whether the sale was a (VAT-exempt) supply of the goods constituted by the property? If it was, the result would be a negative adjustment of the seller/tenant’s input tax recovery under the Belgian capital goods scheme rules.

The contrast with Balhousie is in the CJEU’s adoption of a composite approach to the sale and leaseback, ruling that there can have been no supply of goods, since overall the transactions did not give the buyer (financier) the right to dispose of the property as owner. Also, the seller/tenant continued to use the property for the purposes of its taxable business. In fairness, the technical question was not quite the same as in Balhousie, and the ‘sale’ was the grant of a 99 year emphyteutic lease by the seller to the financier, rather than of the freehold (or Belgian equivalent). It is a tantalising question whether the CJEU would have come to the same view had the sale been of the seller’s entire interest. 

UK real estate VAT has tended to be wedded to form. This is the approach in Balhousie and echoes, for example, the long-held view (before Robinson Family Ltd [2012] UKFTT 360 (TC), that it was impossible for the grant of a lease to be the ‘transfer’ of a property letting business as a going concern. But the CJEU here does seem to be taking a broader approach (and one not merely explicable by the nature of the specific interest sold) in concluding that the sale and leaseback was a ‘single transaction’ for VAT purposes.

Aaron Burchell, counsel, Hogan Lovells (