The European Court of Justice has dealt a blow to the UK government's policy of applying a reduced rate of VAT for the supply and installation of energy-saving and renewable measures such as solar panels.

In a judgment published on 4 June, following the European Commission's decision to take the UK to court over failure to comply with the European VAT Directive, the Court decided that the supply and installation of 'energy-saving materials' in the housing sector did not fall into any of the categories in which a reduced VAT rate (currently 5% in the UK) can apply.

The judgment means that VAT on energy-saving materials will have to be charged at the UK standard rate (currently 20%), a decision which will increase costs for consumers, housing associations, charities and not-for-profit organisations that are unable to recover VAT on underlying costs.

George Bull, senior tax partner at Baker Tilly, said: "This judgment is a further example of the EU's willingness to curtail the UK's legislative freedom, and it presents a direct challenge to the 'triple lock' commitments given in the recent Queen's Speech. Depending on the government's response, it could also lead to higher costs for affected groups seeking to improve the energy-efficiency of their homes."

The UK had defended the reduced VAT rate, stating that its application was for 'social policy' purposes and linked to the UK's Green Deal to improve the energy efficiency of buildings.

However, the EU Court found that while a policy of housing improvement may produce social effects, the extension of the scope of the reduced rate of VAT to all residential property could not be described as essentially 'social'. The Court said as a 'universal' policy, the reduced rate of VAT had been applied irrespective of the housing concerned, and with no differentiation or regard to levels of income, age or other such social interest criteria.

Ian Carpenter, Baker Tilly's head of VAT, added: "The UK has been aware of the European Commission's challenge that it was in breach of EU VAT rules for years, and previously had to address that breach by removing the VAT reduced rate to the installation of energy-saving materials in charitable buildings. Clearly this did not go far enough. Despite this, the UK government must however have been confident that this decision would go in its favour, as the recent Queen's Speech made it clear that new legislation would ensure that there would be no extension to the scope of VAT. This judgment appears to have scuppered those plans.

"We will now have to await how the government will interpret and subsequently react to this decision. It may determine that only social housing tenants can be provided with the supply and installation of energy-saving materials at a reduced rate, and that consequently owner-occupiers must pay VAT at the standard rate. It may also need to find a more efficient way of promoting energy efficient materials while remaining in line with EU VAT law, possibly through the use of direct subsidies. Without addressing such issues, the undoubted impact will be a significant rise in costs for consumers and others installing energy-saving materials in residential homes."

The full EU Court of Justice judgement can be found here: