Construction Insight: VAT and termination payments: Landlord considerations

In September 2020, responding to a recent decision of the ECJ, HMRC issued revised guidance (RCB 12/20) in which it expressed a change of position in relation to the VAT treatment of termination payments.  

It had been HMRC’s view previously that the VAT liability in relation to payments made by a party terminating a contract, such as a break fee under a lease, depended on whether the termination fee had been drafted into the original contract or was negotiated separately. Fees that had been incorporated into the original document were treated as outside the scope of UK VAT, whereas a fee which was negotiated to terminate the contract would be consideration for the “service” of the counterparty releasing the payer from the contract early and was therefore potentially subject to VAT.

HMRC’s revised guidance stated that it would no longer draw a distinction between a fee that was prescribed in the contract and one which was negotiated separately.  
This change of policy is relevant to a range of transactions in the real estate and construction arena and it will be important to review carefully the nature of the payment in each case and to consider what would have happened if the contract had run its course; if taxable supplies would be made to the entity paying the break fee, it is likely that the break fee would be subject to VAT. For example, if a tenant pays a break fee to its landlord to terminate its lease this is likely to be subject to VAT, assuming that the landlord has exercised the option to tax.

In addition, HMRC amended its view on liquidated damages provisions, stating that such payments arise as a result of events envisaged under the contract and as such, they are part of the underlying agreement and are consideration for the goods or services provided under it. Again, a different approach to that taken previously, which had been to treat amounts which are genuinely compensatory as being outside the scope of VAT (since they are not consideration for any supply).

These changes of policy were originally stated to be retrospective but, following an extensive dialogue between HMRC and a number of representatives from industry and professional bodies, HMRC have stated that their new policy will take effect from a future date and that revised guidance (currently under review) will be published to clarify their position on a number of areas.  

Dilapidations

One area which has caused concern is the suggestion from the September guidance that dilapidations payments could be subject to VAT where a landlord has opted to tax (the nature of the dilapidations payment, under HMRC’s revised position, following the VAT treatment of the underlying lease).  The position is under review which means that, at present, landlords can continue to treat dilapidations payments as outside the scope of VAT (and, due to HMRC’s confirmation that the change of policy would not apply retrospectively, there is no need to consider the historic position in relation to payments already received).  

Landlords should however be aware that the position remain unclear and dilapidations payments may, at a future date, be subject to VAT. In the meantime, landlords should ensure that their agreements anticipate this and include a VAT exclusive clause to enable VAT recovery in the event that HMRC’s proposed policy change is confirmed in their revised guidance. 

Please speak to tax partner Julia Lloyd or another member of our real estate tax team if you would like to discuss this.