Overage payments: are they always subject to VAT

Why is there uncertainty?

The initial payment for the sale of development land to a housebuilder will either be exempt or subject to VAT, depending on whether the seller has exercised and notified the option to tax at the time. While housebuilders will normally be able to recover this VAT, this adds other costs, and sellers should consider carefully whether they need to charge VAT. In particular, SDLT is due on the VAT-inclusive price, and HMRC may undertake an inspection before refunding the VAT the housebuilder has paid, creating a substantial working capital cost.

The VAT treatment of goods and services is determined as at the date something is supplied – the ‘tax point’. The grant of a freehold or lease over 21 years (20 years in Scotland) is treated as a supply of goods for VAT purposes. The general tax point for goods is when they are delivered or title passes, so the VAT treatment of the sale of land is normally determined at the completion date.  Even if some of the price is payable in future instalments, all of the VAT would be due on completion.

However, where part of the price of a good is uncertain, only the certain amount is subject to VAT on this date. It is deemed that there is a further supply of the good when each contingent payment materialises.

That raises the possibility that the VAT treatment of the overage payments could be different from the initial payment made for the land. HMRC has previously suggested that this should not be the case, but in their recent guidance, HMRC acknowledge that this happens in some circumstances.

New policy

HMRC confirms that there is a further supply for VAT purposes each time a contingent overage payment crystallises. This is a supply of land, so it could be exempt or taxable depending on whether an option to tax applies at that time. In most cases, the VAT treatment will be the same, but there will be exceptions.

Examples

Scenario 1 – contingent on planning permission A landowner has engaged a promoter to seek planning permission and find a developer. The promoter finds a housebuilder who is confident enough that this will be successful to acquire the land for £100,000 before it has received planning permission. The landowner has not opted to tax, so no VAT is due on the payment for the land. The promoter is subsequently successful in obtaining planning permission for 100 new houses, and a further £10,000,000 overage payment is due to the landowner, with a 15% commission due to the promoter. Realising that it is facing an irrecoverable VAT cost of £300,000 on the promoter’s fees otherwise, the landlord opts to tax. It must charge £2,000,000 of VAT on the overage payment, which the housebuilder can recover (although this may take several months). This increases the SDLT cost to the housebuilder by £100,000, as well as requiring it to obtain additional short-term funding to cover the VAT cashflow.

 

Scenario 2 – contingent on sales A landowner has obtained planning permission for 100 new houses and sells the land it has opted to tax to a housebuilder for £9,000,000. The landowner had opted to tax, so VAT is charged on completion of the land sale (with the housebuilder suffering a higher SDLT charge as a result). However, it is agreed that if any new house is sold for more than £1,000,000, the landowner is entitled to 50% of the additional sales proceeds. By the date that these overage payments materialise, the land is now residential. This means that the landowner’s option to tax no longer has effect, and these payments are exempt from VAT. If the landowner has no other activities, it could deregister for VAT after it has received payment on completion of the original land sale.

Further complications

The VAT treatment of some land sales can depend on how old the building is. In particular, the freehold sale of a new commercial building is always standard-rated, but one that is three years old is exempt (subject to the option to tax).  There is anti-avoidance legislation around the use of overage structures to take advantage of these rules, and the updated guidance does not change this. 

HMRC’s guidance confirms that a payment to be released from an overage obligation is treated in the same way as if the overage was paid. 

With the entire development process typically taking years, sometimes decades, overage rights and obligations can be transferred. The nature of the property could change in the process.  It may be tenanted when one payment is due, but not when another is. It could be a building at one time, and a cleared site later.  

What should landowners and developers do now?

Landowners (and former landowners who retain a right to overage payments in the future) and developers should check that overage agreements reflect HMRC’s updated guidance.  In particular, agreements should be clear whether the landowner has opted to tax, if not, whether it is allowed to opt to tax in the future, and whether amounts due are net or gross of VAT.

For overage payments that have already happened, in the absence of clear guidance, there is a risk that VAT has been charged when it was not due or not charged when it is. The parties should review transactions in the last four years and correct any errors made.  

Making the necessary corrections, obtaining refunds of VAT incorrectly charged, or getting paid VAT where it was due, may be very challenging as one or both of the parties may no longer be VAT-registered, or perhaps even no longer exist at all.  

It is to be hoped that HMRC would be pragmatic resolving these issues, agreeing no adjustments are required in practice, and not issuing penalties where the VAT treatment adopted by the parties at the time was not in line with its updated policy – especially given that it had suggested in some forums that various payments towards the same land should always have the same VAT treatment.  Proactive engagement with HMRC is recommended to manage the process and reduce risks of assessments.
 
Overage arrangements are a good way of reflecting the uncertainties of property development by sharing the risks and rewards between the parties. Careful attention needs to be taken to ensure that an unexpected VAT cost does not arise. Fortunately, HMRC’s updated policy should at least allow a consistent approach to these transactions. 

HMRC guidance available here.