A taxing question around dilapidations

There has been discussion in the property industry as to whether new guidance issued by HM Revenue & Customs requires dilapidations payments to be treated as consideration for a taxable supply. Such payments were seen as outside the scope of value added tax in the past. While most commercial tenants may be able to offset the tax, not all tenants can recover VAT. This issue came to the attention of the Dilapidations Association, which comprises surveyors, solicitors, valuers and other professionals. Seeking to resolve this sort of uncertainty falls within the association’s goals of sharing knowledge and information for the benefit of its members and supporting the wider practice area. The association invites comment on the guidance pending urgently needed clarification from HMRC and advises that legal and accounting advice is sought on a case-by-case basis.. Where we were Whether any individual items in a schedule of dilapidations attract VAT to be paid by the tenant will depend on the landlord’s VAT status and whether the building is optioned to tax. That has not changed. The issue is whether the total damages it is agreed (or ordered) that a tenant should pay are subject to VAT as consideration for a supply to the tenant. HMRC guidance Land and property (VAT Notice 742) states at paragraph 10.12 that: “A dilapidations payment represents a claim for damages by the landlord against the tenant’s ‘want of repair’. The payment involved is not the consideration for a supply for VAT purposes and is outside the scope of VAT”. This has also not changed. The new guidance HMRC’s Brief 12 (2020): VAT early termination fees and compensation payments, updated on 25 January 2021, was intended: “To give an update on the VAT treatment of compensation and similar payments following recent judgments of the Court of Justice of the European Union (CJEU).” It says: “HMRC guidance on charges described as compensation or early termination fees in a contract have been changed to make it clear that they are generally liable for VAT.” Associated guidance can be found in HMRC’s internal manual sections VATSC05910, VATSC05920 and VATSC05930. HMRC relies on the CJEU decision in MEO [2018] C‑295/17, which concerned early termination fees within contracts for telecommunication services. The court held that a clause requiring a customer to pay the remaining fees on termination meant the supplier was receiving further value for the original services. That the customer was no longer using that supply was irrelevant. Reference is also made to Vodafone Portugal [2020] C-43/19, which follows MEO even though the amount payable was not equal to that which would have been due had the contract continued. All scenarios referenced by the guidance relate to a contract’s early termination and a payment made in consideration for that. The guidance says most early termination fees are consideration for a VAT-able supply even if “described as compensation or damages”. What has changed HMRC’s policy is to treat payments arising out of early cancellation as consideration for a taxable supply if the supplies under the contract are taxable. The Dilapidations Association sees an analogy between these situations, for example where a lease is terminated by a break option or forfeiture, and the tenant had agreed a sum to compensate the landlord in such circumstances for its lost future rental income. If VAT was payable on the rent, it would seem consistent to charge VAT on an agreed payment made in lieu. The association does not believe the guidance, which does not have the force of law, covers terminal dilapidations claims where the lease expires by effluxion of time or non-renewal. Those payments will continue to be governed by Notice 742 and, therefore, no VAT will be chargeable. Liquidated damages Preventing parties from categorising cancellation fees as dilapidations compensation to avoid VAT is an understandable anti-avoidance measure. VATSC05930 provides guidance on breaches of contract but only addresses liquidated/pre-agreed damages on a break or forfeiture, which are now subject to VAT. The same is true if the lease contains a formula for calculating compensation. While not expressly referenced, liquidated damages clauses regarding terminal dilapidations that apply whenever the lease ends could also be caught by the principles of HMRC’s guidance. The guidance does seem to treat unliquidated/to-be-determined damages differently from termination fees, even if those damages were triggered by the tenancy’s end. However, the current guidance is quite loosely drafted and a few commentators are concerned that it could be interpreted to cover some unliquidated loss claims. The association questions whether such a wide interpretation is correct and believes that damages for disrepair are not the same as a contractual cancellation fee. Lease parties who agree a surrender often take care to separate dilapidations settlements from surrender premiums for tax reasons. If dilapidations are not settled on completion but are later determined by the court, VAT would not be charged on the award. What if the same dispute was successfully negotiated pre-action with the other surrender terms and the agreed compensation was paid at the same time as the premium? The association would question any assertion that a genuine agreed assessment of unliquidated damages for breach is consideration for the taxable supply under a lease, whether or not the lease ends prematurely. Next steps The association believes HMRC may be reviewing its guidance and another update could be imminent. Chairman Terry Davis has written to HMRC seeking clarification and it is understood that other industry bodies and stakeholders’ advisers have done likewise. Such communications have already been expressly cited as the reason for HMRC deciding not to backdate the guidance’s effect. Follow representations, wording from a December 2020 draft of VATSC05910, which seemed to make more dilapidations payments subject to VAT, was also omitted from later updates. In the meantime, it would be prudent to consider where any VAT risk will lie when negotiating dilapidations claims. Simon Hartley is a partner at RadcliffesLeBrasseur LLP Picture © Shutterstock