The VAT treatment of the payment for the lease termination has always been quite clear. This is a ‘reverse surrender’ where the tenant pays the landlord a fee to take back the lease. This is deemed to be a supply of land, and therefore exempt unless the landlord has exercised the option to tax. In your client’s case they have opted to tax, and so VAT will be due on the payment for the lease surrender. This is confirmed in VATLP02400.
Moving on to the payment for dilapidations, HMRC’s view historically on these payments is that these are outside the scope of VAT as a claim for damages. However this was brought into question by the release of Revenue and Customs Brief 12 (2020): VAT early termination fees and compensation payments(RCB 12/20), which suggested that any payment labelled as ‘compensation’ could be considered as being payment for a supply if it was sufficiently linked to an underlying taxable supply. Does this mean that dilapidations could simply be further consideration for the tenants rent, or further payment for the lease surrender?
VAT Notice 742 (Land and Property) section 10.12 remained unchanged upon issue of the brief stating that dilapidations were outside the scope, but nonetheless HMRC were inundated with requests for clarification specifically relating to dilapidations following the issue of RCB 12/20.
That clarification finally came this week through the issue of Revenue and Customs Brief 2 (2022): VAT early termination fees and compensation payments and the update to the Supply and Consideration Manual VATSC05910. The extract from the manual relating to dilapidations reads:
Another potentially difficult area are dilapidation payments which occur in the land and property sector. These vary in the way they are provided for but broadly they exist to ensure landlords are not out of pocket if buildings are not returned in the agreed condition at the end of a lease. Our policy continues to be that these are normally outside the scope of VAT, see VAT Notice 742 Land and Property.
Again, the question that needs to be addressed is whether the payment is sufficiently linked to the supply of the lease to be regarded as further consideration for it. The service being supplied is the grant of an interest in the premises by way of a lease. It is the lease which creates the obligation to make such dilapidation payments. The obligation to make a dilapidation payment is not inevitable, rather the lease creates an obligation to return the property in the agreed state and it is the default on this obligation that gives rise to the requirement to make a dilapidation payment.
The tenant takes on a package of rights and obligations when entering the lease, one of which is to return the building in the agreed state. The rent will normally reflect those rights and obligations. If the tenant does not fulfil its obligation to return the building in the required state, it is required to make a further payment so the landlord can restore the building to the agreed condition, and it is in effect a re-imbursement of the cost of goods and services that the landlord faces incurring. It is arguable that this therefore represents additional consideration for the supply of the lease. If the obligation to return the building in the agreed state was not there it is probable that the rent would be set higher to allow the landlord to cover the costs of rectifying the building at the end of the contract.
On the other hand, if the tenant had exceeded the wear and tear that might reasonably be expected during the period of the lease, or even undertaken unapproved alterations, the dilapidation payment would be to rectify damage rather than for use of the premises and would be beyond what the landlord agreed the tenant could use the premises for. The link between payment and supply would therefore be broken. Although the payment arguably covers the landlord’s expenses in meeting the tenant’s obligation under the lease it may be difficult to establish that the rent has been set with that in mind. It may be that the rent in reality reflects what the market will bear and would not be increased if the dilapidation clauses were removed from the lease. In that case the dilapidation payment would be made to put right damage and there would not be sufficient link between the payment and the service(s) the landlord had agreed to provide under the lease. It would not therefore be further consideration for the lease.
Our policy having weighed these factors is not to treat dilapidation payments as further consideration for the supply of a lease. We might depart from that view if in individual cases we found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.
So, after a deep breath, payments for genuine dilapidations remain outside the scope of VAT as damages, although HMRC may look at these payments to ensure that the value attributed to the dilapidations is reasonable, and they are not being used to hide part of the consideration for a lease surrender, which as we discussed would be subject to VAT where the option to tax has been exercised.
The new brief also provides further guidance and clarification on the treatment of early termination fees and compensation payments following the confusion caused by RCB 12/20, but this is too broad to be captured in this article.
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