Tax threat to City trophies

Budget measure to close a VAT loophole on office space puts Millennium Tower at risk

New high profile property developments like the proposed Millennium Tower in the City of London are under threat from an obscure VAT clause in the Budget.

The measure has alarmed developers who fear it will force them to raise rents by 20 per cent or more, thus driving down demand. There are worries that it will give Canary Wharf an added edge in its attempts to move Europe's financial capital eastwards.

At least half a dozen large projects - including Trafalgar House's 1,265ft Millennium Tower designed by Sir Norman Foster for the Baltic Exchange site damaged by an IRA bomb in 1992 - and dozens of smaller schemes are at risk.

Among those in doubt are massive projects such as the Paternoster and King Edward's House at St Paul's, Times Square, Broadgate, Britannic Tower and Spitalfields Market developments, which between them were expected to add close to 2 million sq ft of new office space to the 1.8 million sq ft now available. The total City stock is 72.5 million sq ft.

"He has not been kind to us," said an executive with one property company, the morning after the clause was slipped into the Budget. Mr Clarke's only mention of the change in his Commons speech was that he planned to close VAT loopholes.

The loophole in question was a provision called the "option to tax", which allowed developers to get an immediate VAT rebate from the Government, in return for collecting regular VAT payments on the rent for commercial properties.

While most businesses pass the VAT on their rent to their customers, exempt organisations, such as banks, insurance companies, some pension funds and educational institutions are unable to do so.

Instead, some of them set up non-exempt subsidiaries which buy the buildings, recover from the Government the VAT on the purchase, and then collect VAT from their parent institutions on below market value rents. The Treasury estimates the wheeze is costing it pounds 110m a year.

But its solution, denying the option to tax unless 80 per cent of a property is leased to VAT-able companies, leaves developers who build primarily for financial institutions carrying the full tax burden incurred during construction until they are able to recover it through significantly higher rents.

Although the increased rents will be partially offset by the absence of VAT, the carrying costs will still have to be paid for, and developers could face cash-flow problems because of the extra tax load they will shoulder for up to 25 years - the length of a typical City lease.

"The Chancellor is using a sledgehammer to crack a nut," said another developer.

Mr Clarke's tighter rules will mean the cost of a building like Trafalgar's Millennium Tower would rise from about pounds 400m to pounds 470m, plus the financing charges on the extra capital employed - a heavy burden for all but the best capitalised of property companies.

While some developers will stay in the game in the hope that financial institutions will prove willing to pay the extra sums for top quality space, others will get out or postpone their projects. A game of chicken is likely to result, as developers insist they are determined to go ahead to scare others into dropping out.

"It will cause a serious delay to schemes that are being put together," said Nicholas Butterworth, City director of general practice at DTZ Debenham Thorpe, London's leading international property advisor.

Falling demand could be exacerbated as institutions abandon the City for Docklands, Corporation of London officials fear.