Capital project's VAT puzzle in the education sector

Capital projects will always require careful management – they consume large amounts of time and money, are subject to a high level of scrutiny, and tend to be undertaken by the institution’s people in addition to their day job. 

Due to the potential costs at stake, VAT is one of the key factors that needs to be considered when delivering any large capital project. Over the years, various ways of mitigating VAT cost have been tried and tested through the courts. Some of those potential opportunities and pitfalls bear highlighting after some recent cases.

Setting the scene

Most capital projects will incur VAT at the standard rate of 20 per cent, increasing the cost of the project. VAT relief is available in limited circumstances, notably on the construction of new residential accommodation and on buildings that will be used for a relevant charitable purpose, but both require particular conditions to be met.

Where VAT is charged on costs, it is only recoverable where there will be a ‘taxable’ use of the resulting asset. This precludes recovery where there is an exempt business use (educational or residential lettings, for example). Provided that a valid option to tax is in place, taxable business use, such as retail and other commercial lettings, would afford recovery of VAT on related costs.

Leaseback arrangements

A fairly common financing structure for large capital projects is to enter into sale and leaseback or lease and leaseback arrangements. These can take various forms and there can be a range of reasons for using them. One of the main advantages in the education sector is the ability to retain flexibility for the institution to use the new property while easing cashflow.

The VAT implications need to be factored in along with the financial and legal considerations. The very fact that we have many VAT cases in the courts shows its importance to such arrangements.

Two transactions or one?

The VAT relief applicable on the construction of certain types of buildings is clawed back when either:

• there is a change of use of that building; or
• the entire interest in that building is disposed of within ten years of the building being brought into use.

Financing a new building, or upgrading existing buildings, can be facilitated by use of a sale and leaseback arrangement. The case of Balhousie considered whether these arrangements would constitute a disposal that would trigger the clawback of VAT relief, even where the building continued to be used for the same, qualifying purpose before and after.

The Supreme Court held that the disposal of the entire interest in a VAT-relieved building, together with the simultaneous leaseback, does not trigger a repayment of previously relieved VAT. The basis for this reasoning centred around the fact that the organisation did not relinquish its entire interest in the building and continued to have control over how the building is operated by virtue of the leaseback.

Helpfully, a separate case – Mydibel, heard by the CJEU – also found that a sale and leaseback should be treated as a composite arrangement for VAT purposes, rather than as a sale and then an acquisition with VAT treatment applied to each transaction accordingly.

Is the lease a business activity?

The value of rent paid under a sale and leaseback (or any other lease arrangement) also needs to be considered. A nominal payment for the lease that does not have a direct link to the costs associated with making the supply could be seen as falling outside the scope of VAT, on the basis that it is not an economic activity.

Gone are the days when all that was required was an amount of monetary consideration. Among other legal decisions, those in the Gemeente Borsele and Wakefield College cases have determined that a two-stage test needs to be applied:

1. Is there a supply being made for consideration?
2. Is there an economic activity?

To meet the second test, it must be shown that there is a sufficient nexus between the costs incurred in making the supply and the value of consideration received. The VAT status of the transaction is likely to be challenged by HMRC if the consideration does not represent fair value. Careful analysis of these issues needs to be undertaken and the documentation that governs any arrangements needs to reflect the value paid etc.

Consideration for a supply

The recent case of Polo Farm Sports Club also focused on the VAT treatment of a lease and leaseback arrangement.

A dispute arose with HMRC over the VAT liability of the £2m capital contribution from a university to the Polo Farm Sports Club. The sports club was responsible for building the facility, then granted a 65-year lease on it to a university. The university then leased the facility back to the sports club for 65 years less one day, at a peppercorn rent. The sports club retained the freehold on the site and was responsible for the facility’s day-to-day operations. The university was given priority booking rights at certain times and made an annual payment of £250,000 to the sports club.

The sports club took the view that the capital contribution was a provision of finance or grant funding, so was outside the scope of VAT. The lease and leaseback had been put in place solely to give the university security for the funds it had invested.

HMRC successfully argued that the university’s payment of £2m was, in reality, consideration for the grant of the lease to it. The grant of the lease and the payment of £2m were inextricably linked on an economic and commercial basis. Previous cases, including Balhousie, tell us that we must look at the composite effect of linked transactions. As the sports club had opted to tax, this meant that VAT was due on the £2m payment.

Final thoughts

An age-old question that we regularly grapple with is whether funding is a grant and outside the scope of VAT, or payment for a service with VAT applied as appropriate. Polo Farm Sports Club was a perfect storm of both grant vs supply, with the added complexity of a lease and leaseback structure.

Sale and leaseback or lease and leaseback can make sense for lots of reasons, but don’t forget to take advice on the VAT at an early stage. Keep your advisor updated with any changes to the initial plans, and ensure what happens in practice reflects all the good plans laid out at inception. 

For more information, please contact Gillian McGill or Lisa Randall.