HMRC has always recognised that payments for lease surrenders whether by the landlord or tenant – the latter is often known as a "reverse surrender" – are payments for supplies of land, so the payment is exempt from VAT unless an option to tax has been made by the party receiving the payment in which case it will be standard rated.
However, previous HMRC guidance stated that where a contract originally contained a right to terminate early in lieu of compensation for losses arising from the termination, then there was no supply for VAT purposes and the compensation payment was outside the scope of VAT.
Revenue & Customs Brief 12/2020 on the VAT treatment of early termination fees and compensation payments, which was published on 2 September 2020, confirms a change in policy and change of view, following two recent judgments of the Court of Justice of the European Union (Meo and Vodafone Portugal).
HMRC now views any payment for early termination or any cancellation fee as consideration for a supply for VAT purposes (on the basis that these charges are for the supply of goods or services which the customer had contracted to pay under the contract). This will be the case even if the payment is provided for in the contract and even if such a payment is described as compensation or damages.
This means that in the context of leases, where a break clause is exercised to terminate a lease, there will now always be a supply for VAT purposes, which will be exempt (unless the option to tax has been exercised by the party receiving the payment) regardless of whether the break fee amount is provided for in the lease. So, for example, where the tenant pays the break fee it will be subject to VAT where the landlord has opted to tax (whereas previously it would have been outside the scope of VAT on the assumption that it was a compensatory payment included as one of the terms in the grant of the original lease).
HMRC's change in practice applies generally and not just in the context of real estate. For example, HMRC also now considers that a payment of liquidated damages on termination of a contract is also subject to VAT (on the basis that, despite being designed to compensate, the payment is made as a result of events envisaged under the contract).
A liquidated damages payment that is not, however, made on termination of the contract – for example a payment made for late delivery of the subject matter of the contract – may have a different VAT treatment depending on whether it can be characterised as a payment for goods and services or as outside the scope of payment of damages.
(For further detail on how this change in policy affects commercial disputes and settlement negotiations, please see our Insight here.)
Payments for dilapidations
We do not think that this change in policy affects the situation where a tenant pays a landlord an amount in respect of dilapidations (for example, to restore a property to a condition consistent with the repairing obligation in the lease). Our view remains that the tenant is regarded as paying damages for breach of its repairing covenant. As such, the payment should remain regarded as outside the scope of VAT.
Osborne Clarke comment
HMRC's new policy means that the position is much clearer for certain property transactions such as the payment of break fees: when a break fee is paid it will be consideration for an exempt supply (subject to the option to tax). The challenge arising is that the change in policy is retrospective and taxpayers are expected to adjust previous supplies if needed, which could be a burdensome exercise.
Consequently, taxpayers will need to check any previous arrangement in the last four years (the general time limit within which VAT errors can be corrected) involving break fees or liquidated damages under agreements for lease or development agreements to ensure that VAT was correctly accounted for, according to HMRC's new guidance.
The party who is the supplier (for instance, the landlord benefitting from the break fee) will need to consider if VAT should have been charged. Where VAT should have been charged, the supplier will need to check the terms of the contract to see if the original payment has been provided for as exclusive of VAT. If so, it should have the right to raise a VAT invoice and seek recovery of the VAT (and amend its relevant VAT returns accordingly). If not, the supplier may not be able to seek payment of the VAT from the recipient and, instead, will need to treat the original payment as including the VAT and fund its payment.
Where the recipient of the supply is issued with a VAT invoice, it will need to check to see if the invoice is validly raised and should then be able to adjust its VAT returns to recover any VAT paid, if it has the right to do so.
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