18th February 2022
HMRC has finally released the guidance in respect of early termination fees and compensation payments.
You will recall that HMRC released a Brief at the end of 2020 which set out its view that, as a result of certain European Court cases, certain payments which had previously been regarded as being outside the scope of VAT as being payments of compensation or liquidated damages were, in fact, consideration for the original supply of goods or services to which they related. In particular, this included dilapidation payments which were previously always seen as being outside the scope of VAT.
As noted in our communications in both November 2021 and January 2022, our understanding was that HMRC was backtracking on this point, and this has now been confirmed in the recent Brief that HMRC has introduced.
Within the Brief, HMRC has confirmed that if fees are charged when customers terminate a contract early, these will be regarded as further consideration for the supply made. However, when it comes to dilapidation payments HMRC has stated the following:
“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.”
In other words, after a year of deliberating the position, HMRC is back where it started with dilapidation payments being seen as being outside the scope. However, HMRC has provided substantial commentary on the point which, if you were being cynical, might be seen as trying to save face. This is especially in light of the decision of the Outer House of the Court of Session in Ventgrove Ltd v Kuehne + Nagel having raised the question as to whether the Meo and Vodafone Portugal cases, on which HMRC had based their initial change of policy, were at all relevant in the first place.
If HMRC did want to change its policy in this area, then a better argument to support a change would have been not that the dilapidations payment was further consideration for the lease but is a payment to be released from the obligation to repair the building, and so the supply is the release of an obligation.
The positive is that we now have a degree of certainty regarding dilapidation payments and that these will continue to be treated as being outside the scope of VAT.
If you have any queries on the above, please do not hesitate to contact Stephen Patey, Senior VAT Manager.