When the HMRC threatened to charge VAT on design fees in design and build contracts it put the viability of many schemes at risk. Now it seems to have had a change of heart

In the news pages of Building last week there has been a small piece of good news for the construction industry, which makes a refreshing change. It appears that HM Revenue & Customs has seen sense and decided not to implement its proposed changes to the VAT rules in relation to design and build contracts.

While HMRC probably considered these changes to be small beer, it would have served to increase the costs of development projects such as new housing schemes, student accommodation and projects for the voluntary sector by several millions of pounds. This would have had a significant impact all round - to developers who are desperately trying to make the figures work and construction professionals who were looking to these sectors to contribute significantly to their revenue stream and their survival. This should be considered against the back drop of the decline in both private and public sector projects.

The issue is this. Up until June of this year, developers engaged on construction projects that were zero-rated for VAT, were not required to pay VAT on design fees (architect, engineers etc) provided as part of a design and build project where the contractor carries out both the design and construction under a single form of contract. This includes new build housing schemes, care homes, student accommodation and other projects for the voluntary sector - for all of which the cost of purchasing construction services was zero-rated. Outside of the design and build procurement route, any design fees would attract VAT at the standard rate. Clearly, design and build was the way to go. The potential saving on VAT has been even greater as a consequence of the increased design required to deliver those schemes that seek to achieve certain environmental criteria.

Here we have a principal element - the construction work - and a secondary element, design fees. Why should the design fees not be chargeable to VAT?

However, the European Court of Justice (ECJ) ruling in the 2006 case of Talacre Beach Caravan Sales Ltd vs Commissioners of Customs and Excise brought this issue into the spotlight. Talacre supplied caravans that were fully equipped with removable equipment. The current VAT rules allow for the supply of caravans to be zero-rated. Talacre claimed that the removable equipment should also attract the zero-rating. The ECJ disagreed and concluded that the goods in question were to be treated as a single supply comprising a principal item (in this case the caravan), which is subject to the exemption and other items that do not attract the exemption. The fact that the caravan is VAT exempt does not prevent the equipment being chargeable.

This got HMRC thinking and it applied this logic to design and build contracts. Here we have a principal element - the construction work - and a secondary element, design fees. Why should the design fees not be chargeable to VAT? Following consultation, HMRC sought to close the door on the design and build exemption. All design fees, whether under design and build or not, would attract standard rate VAT at 20%.

A small change, but a big effect. Particularly for social housing, student accommodation and relevant projects in the voluntary sector, which would now need to find additional funds to pay the VAT on design fees that would represent between 7-10% of the construction cost. In circumstances where cost appraisals are painfully tight, this could easily have prevented a number of schemes from ever getting off the drawing board, never mind out of the ground. Not surprisingly, there was lobbying and that appears to have paid off - for the time being. HMRC has recently indicated that it does not intend to implement the changes at the moment.

There is a delicate balance to be achieved between the need to maximise revenue through taxation and keeping the industry going. But for now, my advice would be to take advantage of the good news and get into contract.

Charles Tomlinson is a partner and head of the construction team at Weightmans