VAT treatment of payment to exercise break clause

This uncertainty arose because, in September 2020, HMRC issued a Revenue & Customs Brief 12/20 (the Brief) regarding early termination fees and compensation payments. The Brief stated that following the Court of Justice of the European Union (CJEU) cases of Meo and Vodafone Portugal, it had become evident that such charges are normally considered as being for the supply of goods or services for which the customer had contracted, and that this was the case even if they were described as compensation or damages.

HMRC went on to state that any person who had failed to account for VAT on such payments should do so unless they had received specific advice from HMRC that such payments were outside the scope of VAT, in which case they only needed to account for VAT from the date of the Brief.

To say this caused some consternation, particularly with regard to payments in the property sector, is probably an understatement, and the Brief was quickly updated and re-issued on 25 January 2021. This stated that the updated VAT treatment set out in the Brief would only apply from a future date, but until then businesses could either continue to apply the previous treatment or follow the amended guidance – a sort of ‘do what you want’ tax policy.

As at the date of writing (7 January 2022), HMRC have issued no further updates to the Brief but have alluded, in their response to the call for evidence on the land and property VAT exemption, that guidance will be issued in February 2022 and that it is unlikely that dilapidations will become subject to VAT.

Where are we now?

The Outer House of the Court of Session (broadly equivalent to the High Court in England & Wales) released its judgement in the case of Ventgrove Ltd v Kuehne + Nagel on 22 December 2021. The case was not of itself a VAT case but depended on the VAT position of a type of payment referred to above.

Essentially Kuehne + Nagel was a tenant in a building owned by Ventgrove Ltd which had opted to tax the building. The lease had a break clause in it which could be exercised on payment of a fee plus VAT where applicable. Kuehne + Nagel sought to exercise the break clause in February 2021 after the amendment to the Brief had been issued.

They made the appropriate payment, but without VAT. Ventgrove Ltd took Kuehne + Nagel to court arguing that the break clause had not been validly exercised because the amount paid did not include VAT, which Ventgrove Ltd said was due.

The Court, perhaps not surprisingly, found for Kuehne + Nagel because as at the date of the exercise of the break clause, HMRC did not require VAT to be payable on a payment made in order to exercise a break clause under their policy prior to the issue of the Brief. They also did not require payment after the issue in the month before the break was exercised of the update to the Brief.

However, the interesting comments in the case are when the Court remarks that there has been no case where a court or tribunal has considered whether the exercise of an option to terminate a lease which is contained within the original lease is a taxable transaction. Nor was it the Court of Session’s job to do so since it was being asked not to opine on a VAT liability question, but on whether a break clause had been validly exercised.

It then, significantly, went on to remark upon the fact that the Meo and Vodafone Portugal cases, on which HMRC had based their initial change of policy in the Brief, related to compensation payable by the customer for terminating fixed period telecommunications contracts prior to the end of the fixed period and as such, “these cases are not directly in point.”

Compensation for failure to complete a minimum contractual term, calculated by reference to the remaining monthly charges, was not the same as a contractual entitlement to bring a contract to an end after a specified period upon payment of a fee. Nor was the lease terminated prior to the expiry of a minimum period, but at the end of a minimum period. The amount payable to exercise the break was not calculated based on any rent foregone because no rent had been foregone given that there was a contractual right to exit the lease at that time. Similarly, dilapidations are payments for damage done, not compensation for lost earnings.

Whilst the Court did not need to determine what the VAT position of a payment to exercise a break clause to answer the question it had been asked, the comments it makes do raise the question of whether the CJEU cases (which HMRC relied upon to seek to change its long established policy) are at all relevant and have any impact beyond the facts of those specific cases.