Dealing with risks in mixed-use service charges

Given the varying legislation that applies, dealing with service charges for mixed-use developments can be a potential minefield. It therefore requires considerable diligence, and a strong understanding of both residential and commercial governance.

Even simple tasks such as the production of year-end service charge reconciliations have different time frames depending on their purpose. 

While commercial year-end accounts need to be produced within four months of the year-end to adhere to RICS' Service charges in commercial property, best practice in the residential sector dictates that they must be produced within six months of the year-end in order to avoid legal ramifications such as fines being levied under section 25 of the Landlord and Tenant Act 1985.

What therefore should be the time frame for producing mixed-use accounts? 

When deciding how to manage your mixed-use service charge, one of the key considerations is the potential risk. Residential management requirements tend to provide more easily available legal recourse for occupiers than the commercial sector, which is based more on best practice. 

However, as exampled above, in some instances the commercial sector may have more stringent guidelines. Therefore, you need to ensure that you are always following the correct process in all aspects of management.

Among a vast number of possible issues, three specific areas pose a significant risk of costs to you or your client if not treated correctly:

• VAT on utilities
• spending limitations on the residential service charge
• the 18-month rule for residential service charge recovery.

This is relatively straightforward to determine on sites where there is only a single type of occupier. However, it is not always straightforward for mixed-use sites.

If you apply the reduced rate you will need to prove on what basis you have done so should HMRC query it; so it is important that you undertake a thorough review of your usage to allow you to back up your claims. 

Depending on the sophistication of your building, this can be done either by an analysis of the metering through the building's management system or, more simply, by splitting the supply by area or a similar apportionment. 

Where you determine that the 60% threshold has been reached, you will need to notify your suppliers and get a VAT declaration form sent across to ensure your rate is reduced to 5%. Some suppliers will allow you to apply for previous years to be re-billed; but this is at their discretion, as they are not obliged to do so and will not refund CCL charges that have been paid incorrectly.

Leaseholders could request that the service charge is refunded by the amount that they have overpaid and if these monies cannot be recovered from the utility company, the landlord may be deemed liable to pay it back if the issue was taken to the First-tier Tribunal and they ruled the landlord was at fault.

Section 20 of the Landlord and Tenant Act 1985, as amended by the Commonhold and Leasehold Reform Act 2002, was implemented to protect the financial interests of residential leaseholders by ensuring that landlords were not using service charges for personal gains by appointing companies they benefitted from and market prices were benchmarked when placing orders for works.

The legislation dictates that leaseholders must be consulted to keep them apprised of the landlord's intention to undertake the works and the justification for them, as well as having an opportunity to comment and nominate a contractor to undertake these works.

It is worth noting that section 20 and the required consultation process only take effect when works will cost any one leaseholder £250 or more. Administrative or professional costs such as surveyors' fees or health and safety inspections are not defined as works to a building, though, and would not therefore be subject to the legislation.

The legislation further provides leaseholder protection in respect of longer-term agreements. These are defined as qualifying long-term agreements (QLTAs), which cover any arrangement between landlord and leaseholder for the benefit of a building for longer than 12 months, such as maintenance, management and utility contracts. 

Notably, employment contracts are excluded from this and will not amount to a QLTA. The threshold at which the legislation takes effect for a QLTA is £100. 

This should be of particular interest to managing agents when setting the terms of their management agreement, if that is for a period of more than 12 months. 

Where an agent is managing a building of ten units and each contributes an equal 10% service charge apportionment, and that agent implements a management agreement with the landlord for more than a year, the maximum management fee that could be taken without consulting leaseholders and obtaining alternative quotes would be £1,000.

This is why many agents will opt for a 12-month agreement despite the security of a longer contract. 

It is also important for agents to consider how the agreement rolls over at expiry, because if there is an indication that the contract continues in perpetuity unless ended this may constitute a QLTA, and therefore be subject to the terms of the legislation. 

Any existing QLTAs you have should be reviewed, and you should check that leaseholders have been consulted before these were put in place. However, if a developer has placed a contract before any leaseholders take complete possession of their property, this will negate the requirement for consultation. 

As this legislation is only relevant if you manage residential properties, commercial managers need to be versed in the risk this carries if this is not at the forefront of their minds in mixed-use schemes, which we look at in the next part of the article.

What makes this even trickier to manage is that these section 20 thresholds were set in 1985 and have not been updated to take inflationary factors into account. Therefore, the threshold at which the legislation takes effect is now considerably lower in real terms.

This is why it is so important to ensure that anyone placing orders on behalf of a landlord is aware of the spending limits. Never assume that your section 20 thresholds will be significant just because a large amount of the costs are funded by your commercial tenants.

For example, if you had three leaseholders with equal service charge contributions as per the lease, the threshold of what they could contribute for a QLTA would be £300 per annum. 

If, however, the flats were as shown in Table 1 and flat A was twice the size of flats B and C, then the limit would be reduced to £200. This is because flat A would pay 50% of the total service charge and flats B and C would pay 25% each. So if flat A can pay a maximum of £100 and flats B and C only contribute half as much, then the maximum they could contribute would be £50 each. 

The same methodology applies to one-off works; however, the maximum any one leaseholder can pay would be £250. Remember to refer to the lease in all cases, to ensure that your apportionment aligns with its terms. 

To put this into practice, we will use the residential apportionments from Table 1 and apply them to a situation where you want to instruct works from a schedule shared with the commercial leaseholders where the total floor space is 1,000m². 

The residential leaseholders equate to 200m², meaning that they need to contribute 20% of the total cost. As the limit for a leaseholder is £250, flat A would pay £250 and flats B and C £125 each, so the residents could contribute a maximum of £500 including VAT. Therefore any repair works that cost more than £2,500 including VAT would require consultation. 

It is important to be aware of the section 20 process if managing a mixed-use service charge: if this is not followed specifically, landlords leave themselves liable to cover any and all costs above the threshold at which they should have consulted their leaseholders.

To limit confusion and ensure complete transparency when drafting section 20 notices to leaseholders, always show the full amount of the contract, including VAT, and what proportion of the total costs the different residential and commercial occupiers pay.

If a leaseholder requests to inspect the tender documents, which they have a right as part of the section 20 consultation process, this will ensure that the numbers received match what has been stated on the notice of estimates and alleviates any potential misunderstanding. 

If not handled correctly, any costs that breach the section 20 limits without consultation taking place will need to be funded by the landlord.

This notification can be in the form of a demand or a notice. However, failure to notify would result in the costs being unrecoverable and left as a liability to the landlord.

In OM Property Management Ltd v Burr [2013] EWCA Civ 479, the Court of Appeal found that, for the purpose of service charge management, costs are deemed to be incurred at the earlier of the time of receipt of an invoice by the landlord or the point at which they pay it.

This point was further clarified in Ground Rents (Regisport) Ltd v Dowlen [2014] UKUT 144 (LC), in which the Upper Tribunal (Lands Chamber) concluded that a cost is only considered to be incurred when it is passed to the current landlord as opposed to any predecessor. 

In Ground Rents, historic water bills of up to £80,000 had been sent to the previous landlord, who did not pass them to the current landlord for a number of years. 

The Upper Tribunal found that the cost of the water supply had not been incurred until the bills had been passed to the current landlord, and only then did the 18-month period to pass the costs on to leaseholders in turn through the service charge begin.

It is important to note that this 18-month period applies only to any lease immediately under a landlord. In a case that concerned a chain of subleases, Westmark (Lettings) Ltd v Peddle & Ors [2017] UKUT 449 (LC), the Upper Tribunal ruled that the period resets with each sublessee to whom a cost is passed down. 

If a leaseholder finds themselves at the end of a long chain of leases, the result is that they may find historic charges from years before their ownership being presented to them that will be payable as long as no more than 18 months have elapsed between the landlord passing the cost on to the tenant, and so on to any subtenants below them.

Making sure you accrue any missing known costs in your end-of-year service charge reconciliation will ensure that they will be recoverable if invoices are missing, or you are unable to make payment.

If you are unable to produce your year-end accounts for any reason, a section 20B(2) notice should be served on leaseholders within six months of the year-end. This notice will outline the expected expenditure in the year and satisfy section 20B, as leaseholders will be informed within the 18-month period.

However, if you fail to send out a section 20B(2) notice it does not mean that costs cannot be recovered. As long as you have sent the notice by the point in the year when expenditure exceeds the payments on accounts received you will be able to recover them, as illustrated in Holding & Management (Solitaire) Limited v Sherwin [2010] UKUT 412 (LC). 

Failure to reconcile a mixed-use service charge within six months of year-end – which may include accrued costs – or issue a section 20B notice will mean that the costs become unrecoverable and therefore the landlord will become liable.

Therefore, ensure you have the correct personnel to provide expertise in both the residential and commercial fields, and remember to wear both your residential and commercial hats at all times.