As you were! HMRC decides no VAT payable on dilapidations payments after all

After a long period of uncertainty, HMRC have finally issued their decision as to whether or not valued added tax (“VAT”) is chargeable on dilapidations payments.

Historically, dilapidations payable by a tenant at the end of a lease had not been subject to VAT.  The payment was to compensate the landlord for having its premises returned in disrepair, contrary to the tenant’s promise to keep them in repair.  Truly compensatory payments have historically been treated as not subject to VAT as it was considered they were not payments for a supply of goods or services.

This settled position was thrown into doubt by HMRC’s Revenue and Customs Brief 12 (2020) Revenue and Customs Brief 12 (2020) VAT Early termination fees and Compensation Payments published in September 2020 (“R&C Brief 12/20“), which announced a change in HMRC policy such that compensation payments would generally be subject to VAT.  This change of HMRC policy was prompted by two judgments of the Court of Justice of the European Union (“CJEU”):

• In MEO (Case C-295/17), the CJEU held that a termination fee payable by a customer for breaking a contract early incurred VAT. The amount of the termination fee had equalled what the customer would have had to pay under the remainder of the original contract.  Described in this way, the court found no difficulty in finding that Portuguese telecoms company MEO was still supplying a service, but one that the customer chose not to take.
• In Vodafone Portugal (Case C-43/19), the customer again terminated the contract early and became liable to pay compensation. Vodafone’s loss was restricted under Portuguese law to its cost of providing the service.  Vodafone therefore argued that the payment was compensation, not linked to supplies under the contract, unlike MEO.  However, it failed to convince the CJEU, which held that the character of the payment did not change because, from an economic perspective, the amount payable on early termination was an integral part of the price the customer agreed to pay under the contract.  The payment was therefore counted as consideration for a service and was subject to VAT.

It is quite a leap to go from these consumer contract cases to dilapidations in the commercial landlord and tenant sector.  However, by analogy, it is arguable that dilapidations payments could also be considered as an extra tenant payment for using the premises (which would be subject to VAT provided that the landlord had opted to tax the property).  If the tenant were not under an obligation to return the premises in the state it had leased them, then it would likely pay a higher rent to reflect that.  This raised the prospect of landlords and tenants collaborating to avoid the payment of rent by passing off the repairing covenant as a compensatory payment.

Though this argument has a certain logic, this is not how repairing covenants and dilapidations have historically been characterised.  This is underlined by s18 Landlord & Tenant Act 1927 which states, in essence, that damages for dilapidations are de minimis if the landlord is intending to redevelop or demolish premises.  Dilapidation payments are not windfalls for the landlord, they are monies to enable them to put back their premises into a state where they can be re-let.

It has long been accepted that a premium payable by the tenant to surrender a lease early, or the premium payable by a landlord to a tenant for early retrieval of the premises, are taxable (provided that the supplier has opted to tax the property).  Consideration passes between the parties – in return for giving up or being released from a legal obligation, money changes hands.

The pushback against R&C Brief 12/20  was strong.  In January 2021, following representations from businesses and advisors, HMRC announced that it would be issuing new guidance.  In the meantime, HMRC said that businesses could either apply the 2020 guidance and treat payments as subject to VAT or go back to treating them as outside of VAT in accordance with HMRC’s former guidance.  This left landlords in limbo for over a year whilst HMRC cogitated on its new stance.

The new guidance – Revenue and Customs Brief 2 (2022): VAT early termination fees and compensation payments and related updates to HMRC’s VAT manuals, published on 7 February 2022 – is effective from 1 April 2022.  It is now official: dilapidations will normally be outside the scope of VAT (although HMRC has confirmed that it may depart from this view if it finds evidence of value shifting from rent to dilapidations payments to avoid accounting for VAT).  There may be more room for debate in the wider area of early termination fees and other compensation payments, and HMRC have said that in circumstances such as the MEO and Vodafone Portugal cases VAT will be payable, but for now, with dilapidations settlements, common sense has won the day.

***

If you wish to receive periodic updates on this or other topics related to UK real estate, subscribe to our Real Estate Insights mailing list.

For any other legal questions related to UK real estate, please get in touch with your usual Mayer Brown contact or one of the blog editors.