VAT Treatment of Remedial Construction Works – New HMRC Guidance and Impact on Developers and Contractors

The current Labour government’s manifest stated that it will “take steps to accelerate the pace of remediation across the country” in relation to building safety and regulations. This makes HMRC’s newly published guidance (‘Revenue and Customs Brief 3 (2024): VAT on cladding remediation work’, and ‘Help with VAT treatment of remedial works — Guidelines for Compliance GfC11’) regarding the VAT treatment of remedial construction works all the more important.

The issue

Following the 2017 Grenfell Tower tragedy, focus has increased on compliance with building safety regulations, which in practice has led to many buildings requiring remedial construction works. This raises the issue of how such works should be treated for VAT purposes. Prior to the release of HMRC’s Business Brief 3/2024 and GfC11, HMRC’s view of the VAT position for remedial works varied, creating substantial uncertainty across the construction sector, although HMRC states that the new guidance does not change existing policy.  This article focuses on the VAT liability of remedial works and the recoverability of any VAT incurred on such works, but it is also important to consider the VAT reverse charge and construction industry scheme (“CIS”) position for such works (a discussion of which is outside the scope of this article).

Construction and remedial works are normally subject to the standard rate of VAT and will only be zero-rated if supplied in the course of “constructing a qualifying building”.  However, where remedial works are required later, perhaps following the sale of a building from the developer to an occupier, social housing provider or management company, the VAT treatment is less clear. A question arises whether the remedial works are supplied in the course of construction of a qualifying building (and are therefore zero-rated) or supplied under a new contract once the building is no longer in the course of construction (and therefore standard rated). 

HMRC’s Approach

In its updated guidance, HMRC uses the term “snagging” to refer to “remedial works to correct faulty workmanship or replace faulty materials”. Where “snagging” works are carried out under the terms of the original construction contract,  such works will form part of the original supply of works of construction or conversion of a building, rather than a separate supply of works to a completed building, and VAT relief should be available at the rate applicable to the works under the original contract. 

If the original supply was zero or reduce rated for VAT, there are four conditions which, if satisfied and supported by appropriate documents, indicate to HMRC that the remedial works would be classified as “snagging” works carried out as part of the original supply of works to construct or convert a qualifying building:

1. there must be a fault to the original construction of a qualifying building that was constructed at the zero or reduced rate of VAT;
2. there is an obligation to correct the fault under the original contract;
3. a person with “person constructing status” must undertake the remedial work to satisfy the link to the original construction; and
4. there is no new or additional supply or charge made for the remedial work by the original developer or the original contractor. 

In the most straightforward cases, the snagging work will be carried out by the original developer under the terms of the original contract, in which case the snagging works should be treated as part of the original supply of construction services and will receive the same VAT treatment so, if the original supply was in the course of constructing a qualifying building (and, accordingly, the original works were zero-rated), the snagging works should also be zero-rated. 

However, the above conditions can lead to a variety of outcomes depending on the facts, as explored below.

Remedial works needed due to changes in building safety regulations

If a building was constructed in accordance with the contract (including the relevant building regulations in force at the time) and a certificate of practical completion (PC) issued, any remedial works required years later to bring the property in line with new building regulations will be seen as a new standard rated supply of services for VAT purposes.

Remedial works needed due to faults in the original construction

If the developer still owns the completed qualifying building and it becomes apparent that there are faults with the original construction which are remedied by the original contractor, these works would be subject to VAT at the same rate at the original construction (meaning they could be zero-rated). However, if the developer engages a third party contractor (rather than the original contractor), HMRC will likely take the view that the remedial works are a new standard rated supply.

Input tax recovery

On the basis of this clarification by HMRC, developers will be faced in many cases with a standard rated VAT cost from contractors that may give rise to a cashflow concern (subject to the VAT reverse charge position) or which may not be recoverable.

HMRC confirms that input VAT recovery by developers on remedial works will be subject to the normal rules. Accordingly, VAT may be recovered if there is a direct and immediate link between the cost incurred and: (i) a specific taxable output supply, or (ii) a taxable business activity as a whole.

HMRC helpfully provides examples of how the above guidance may be applied.

Remedial works under the original contract

If a developer builds and then sells an apartment block to a landlord pursuant to a zero-rated freehold grant, and then supplies remedial work to the landlord under a warranty in the original sale contract (whether using the original contractor or a new contractor), the remedial works would still be treated as having a direct and immediate link to the original zero-rated freehold sale.  Supplies made by the contractor should therefore be zero-rated, so no input VAT should be incurred.

Remedial works not under the original contract on an apartment block let on exempt leases

In contrast, if the original developer retains and lets the apartment block on exempt short leases (possibly after having made having made an initial taxable supply of granting a zero-rated long lease) and hires a contractor to carry out remedial works to bring it in line with new regulations, this is not pursuant to the original construction contract.  The contractor should therefore charge at the standard rate of VAT. However, if (as in this case) the remedial work has a direct and immediate link to exempt supplies, this input VAT would not be recoverable.

Remedial works with a direct and immediate link to the general activities of the business

If a developer sells a block of flats and safety issues are later discovered relating to certain materials used in the construction (such as dangerous cladding), and the developer agrees to engage a contractor to replace the materials to protect the developer’s reputation and potential impact on future trade, there would be a direct and immediate link between the input VAT incurred by the developer and the general activities of the business.

Accordingly, assuming the developer is a fully taxable business, input VAT should be recoverable in full.

But what if the developer is obliged under new legislation to correct a fault?  Can it be argued that the cost and input VAT in this case are referable to the general activities of the business if the developer is not making a decision to preserve its reputation or future trade?  HMRC suggests that such supplies would also be referable to the general activities of the business, by preserving future business, ensuring future operation of the business, including ‘…avoiding limits being placed upon the size of future planning permission or development rights.’

This would not, however, avoid a restriction on VAT recovery if the developer is a VAT exempt or partially exempt business; further planning may be required in such cases.