HMRC’s u-turn leaves the VAT treatment of break payments uncertain, write Julia Cockroft, Dhara Mulumudi and Fiona Moignard.
HMRC’s interpretation of two Court of Justice of the European Union cases set out in the policy paper Revenue and Customs Brief 12 (2020): VAT early termination fees and compensation payments, published in September 2020, demonstrates a significant change to the long-established view that payments made in connection with early termination and cancellation of a contract are generally outside the scope of VAT as compensation or damages.
This article will explain HMRC’s new position, consider the implications for payments made on exercise of a break right in a lease and dilapidation settlement and note how landlords and tenants can minimise the impact.
Break payments: the former position
Until recently, where a pre-agreed contractual right to terminate a lease was exercised in return for a specified payment, HMRC did not consider this to be a supply of land. Instead, such payment was considered compensatory in nature and so not VAT-able.
Updated guidance
The key elements of RCB 12/20 are as follows:
- Early termination and cancellation payments are further consideration for the supply of goods and services pursuant to the cancelled contract.
- Such amounts will be subject to VAT if the underlying supplies under the contract were or would have been subject to VAT.
- Whether payments are described as compensation or damages is irrelevant.
Although the cases referred to in RCB 12/20 were concerned with payments made in connection with mobile phone and telecoms contracts, it is clear that HMRC intends to apply the principles widely, including to payments made in connection with real estate leases. This means that where a landlord has opted to tax a property, any fee paid by a tenant to break the lease will be subject to VAT.
The current position
RCB 12/20 received extensive criticism, in part because it was published without consultation with stakeholders and particularly because it initially purported to have retrospective effect, suggesting taxpayers ought to take immediate steps to correct historic “errors”. In response, HMRC issued the following statement on 25 January 2021:
“HMRC has decided to apply the updated VAT treatment set out in the brief from a future date. We will issue revised guidance, and a new Revenue and Customs brief to explain what businesses need to do shortly.”
Frustratingly, taxpayers are still waiting for clarity. HMRC published a response to the consultation on reforming the option to tax rules on 30 November 2021, which indicates that updated guidance on this issue may follow “early next year”.
In the meantime, HMRC has suggested that it is open to taxpayers to choose what VAT treatment to apply to a termination payment, so the supplier (ie landlord) can either:
- treat such payments as further consideration for the contracted supply and charge VAT where applicable; or
- treat such payments as outside the scope of VAT if this is how they previously treated them.
So where does this leave us?
The ambiguity surrounding the VAT treatment of break payments and the possibility that a revised position could be issued by HMRC at any time poses a real issue for the real estate industry. As break notices are strictly construed by the courts, there is a significant risk for a tenant of the break being ineffective if the conditions are not adhered to. This can have considerable cost consequences for a tenant, tying them in for the remainder of the term of their lease.
If VAT is not charged on a break fee at the point a break notice is served and updated HMRC guidance is then issued confirming that the correct view is that the payment should be treated as “further consideration”, could there be an argument for the landlord that the conditions to exercise the break have not been complied with?
Conversely, if a landlord chooses to charge VAT on a payment made on termination of a lease and HMRC subsequently determines that VAT should not apply to such payments, is there a risk that HMRC could deny input VAT recovery by the tenant on the basis that VAT has been incorrectly charged by the landlord? The tenant could seek to recover the incorrectly charged VAT from the landlord but may not have sufficient bargaining strength to argue for the inclusion of the necessary protective reimbursement provisions at the time it exercises a break right.
Tenants considering exercise of a break right should closely monitor HMRC’s statements and guidance. In the absence of HMRC issuing clarifying guidance, tenants should seek to agree with landlords in advance of serving a break notice that the break fee will not be treated as VAT-able and that the fact that no VAT has been paid will have no impact on the validity of the break.
A point on dilapidations
VAT notice 742, paragraph 10.12 continues to state that a dilapidation payment is a claim for damages by the landlord against the tenant’s “want of repair”. This has been widely understood to mean that dilapidations are outside the scope of VAT.
Since dilapidations are compensatory in nature and generally paid on termination of a lease, there were initial concerns that they may be caught by the wide wording of RCB 12/20. However, HMRC has indicated that it does not intend to treat dilapidation payments as further consideration for the supply of a lease, and therefore they should continue to fall outside the scope of VAT.
HMRC has warned that it may depart from this view if in individual cases it is found that landlords are value shifting from other VAT-able payments made under a lease (eg rent or, subject to the outcome of the uncertainty noted above, break fees) to dilapidation payments to avoid accounting for VAT. It will be increasingly important to have a clear schedule of dilapidations that can be used to justify any payments that are described as dilapidation payments.
Julia Cockroft is a senior associate (tax), Dhara Mulumudi is a trainee (real estate) and Fiona Moignard is a paralegal at Bristows
