VAT Reclaims for a partially-exempt developer

This query relates to reclaiming input tax for a partially-exempt VAT-registered limited company.

A developer purchases three residential properties through his company, in order to secure the land whilst seeking planning permission for some new-build houses. Whilst grinding through the planning process, which unexpectedly takes three years, he rents out all three houses on assured shorthold tenancies to help cover his costs. During this time he makes no other VATable supplies: he just incurs development costs, rental-related costs and the residual costs of operating the company. His intention is to demolish House 1 and replace it with some new flats; Houses 2 and 3 are side-by-side on a separate site three miles away, where he intends to demolish House 2 and replace it with two new ones. He needs to own House 3 in order to provide vehicle access and a strip of extra land for the new-build houses, and because there is further planning potential by combining the land at the rear of the plots. All the properties, including the surviving House 3, will be sold as soon as the new-builds are complete, market conditions permitting.

The developer can reclaim all input tax incurred in the course of developing and constructing the new-builds: on architects’ fees, for example, plus professional inspections and direct construction-related costs, because he will eventually make a zero-rated supply when he sells the new houses and flats. What however of the input tax incurred during the 3-4 years of renting out the original houses, for example on gas safety inspections, repairs and maintenance work, and enhancements intended to improve the rental prospects of the un-demolished House 3? The advice in VAT Public Notice 706 - Partial Exemption and in VAT Information Sheet number 7/08 only deals with situations where a builder constructs a new house and then decides to rent it out temporarily before selling it. Nothing is said about when an existing property is rented out and then demolished before a new-build begins.

One perspective might argue that none of the rental-related input tax can be reclaimed because renting and any refurbishment of second-hand properties is VAT-exempt. This is how one would handle a conventional investor landlord – he can’t reclaim VAT at any point on houses he buys, rents out, refurbishes and eventually sells on. However, all three houses in this example were purchased as part of what are demonstrably new-build development sites from the start, so it could be argued that all the input taxes should be reclaimable, especially as the exempt items total less than the de minimis £7500 p.a. limit when calculated on a yearly basis. It’s unclear though if the de minimis rules apply to existing properties rather than new-builds.

I think I need to propose a Special Method here to reclaim as much as possible of the exempt VAT. Any suggestions on how to do this? Do I work out the proportion of exempt VAT for each property, which means House 3 has no basis for a reclaim (it’s only been rented, improved, had the land divided up, and then been sold on), or do I argue that Houses 2 and 3 need to be treated as one overall site?

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