Fee-paying FE students and community groups are being treated like "second-class citizens" and barred from using new college facilities because of a "perverse" anomaly in VAT rules, principals have said.
Colleges are exempt from paying VAT on new buildings which are predominantly used for teaching 16 to 18-year-olds, but must pay tax if more than 5 per cent of a building's usage is income-generating.
HM Revenue and Customs includes teaching for fee-paying adult learners aged 19 and over in this bracket, meaning more mature students are being shunted into older classrooms as cash-strapped colleges look to avoid paying an extra 20 per cent towards building costs, following this month's VAT increase.
In another Catch 22-style incongruity, colleges intending to generate extra income by hiring out their facilities are also forced to pay extra VAT costs if they exceed the 5 per cent limit.
In contrast, schools do not have to pay VAT on construction costs.
An HMRC spokesman told FE Focus it was unable to change VAT rules because of EU legislation.
Julian Gravatt, assistant chief executive of the Association of Colleges, said: "It just creates perverse financial incentives for colleges to be shut in the evenings rather than open to the community."
Nigel Robbins, executive director of the Tertiary College Group, is calling for colleges to be made exempt from VAT on construction costs - but to keep HMRC happy by paying tax, ideally at a reduced 10 per cent rate, on any income derived from hiring out their facilities.
The former Cirencester College principal said: "We have to use second- class facilities for older students and treat them like second-class citizens.
"Planners invariably ask if we are going to be using facilities for community use. We have to say yes, but it will just be for 5 per cent of the time. It's frankly bizarre."
The extra VAT costs come while colleges are being encouraged to diversify their income streams as they look to offset sector-wide funding cuts.
Community use is also often a prerequisite for obtaining planning consent from a local authority.
Colleges can opt to pay VAT on parts of a building used by fee-paying students or community groups and not have to pay it on the rest.
The dilemma is the latest obstacle faced by colleges, which are struggling to attract capital funding in the wake of the collapse of the Building Colleges for the Future programme in 2009.
A BIS spokeswoman said: "The VAT laws do not leave much room for manoeuvre without compromising the colleges' status as an independent body, especially as we are unable to change UK VAT law because this hangs on European VAT law.
"Neither the college nor government would want to restore the college to local authority control simply to equalise the VAT position."
The HMRC spokesman said: "HMRC accept that a building can be zero-rated, providing its relevant use is at least 95 per cent.
"Reducing the relevant use below this figure would constitute an extension of the zero rate, which we are prevented from doing under agreements with our EU partners."