The Final Word – VAT on Dilapidations

Lewis Mills | 27 October 2022

The Final Word – VAT on Dilapidations

The matter of whether VAT is payable on dilapidations claims has been hotly debated in the property industry over the past few years. Several conflicting guidance documents from HMRC in recent times have inadvertently confused the matter further, leaving tenants, surveyors, and landlords without a definitive answer.
To bring about an end to all the confusion, we have decided to address the matter head on by publishing the final word.

 

Termination Fees & Compensation Payments

Pre-2020: VAT NOT APPLICABLE

Prior to 2020, HMRC guidance stated that when tenants paid sums to withdraw from agreements to receive goods or services, those payments were outside the scope of VAT.

September 2020: VAT IS APPLICABLE
This position changed in September 2020, when HMRC published Revenue & Customs Brief 12 (2020), stating that payments as described above would now be subject to VAT with retrospective effect, regardless of whether the payments were described as compensation or damages.
As a result, dilapidations payments which were genuine damage payments became subject to VAT.

January 2021: VAT not applicable on dilapidations claims pre-Sept 2020
Four months later in January 2021, HMRC announced that it was revisiting its September 2020 brief, dropping the retrospective effect element of the September 2020 brief until their revised guidance was published.

February 2022:
On 7th February 2022 HMRC published updated guidance on early termination fees and compensation payments: Revenue & Customs Brief 2 (2022) setting out its new position, re-confirming that:

“early termination fees payable in respect of a contract will usually be treated as further consideration for the underlying supply as provided for in that contract.”

In short, if a lease had not been terminated, if VAT would have been due on the sums which are being paid e.g. rent, then VAT will be payable on dilapidations.

This will be the case when the lease has provisions for an early termination such as exercising a break option or when a separate agreement is reached to bring the contract to an end such as a deed of surrender. So, if a tenant is to make a “bullet payment” under the break clause, the tenant will be required to pay VAT on that payment where the landlord has opted to tax.

Terminal Dilapidations Payments

HMRC, in its February 2022 brief, confirms that terminal dilapidations payments (i.e. the genuine payment made by the tenant to the landlord for breaches of the tenant’s repair covenant contained in the lease) are outside of the scope of VAT and so genuine terminal dilapidation damages payments will not attract VAT.

HMRC have confirmed that it may depart from this new position if it finds evidence of “value shifting” from rent to dilapidations payments to avoid accounting for VAT, e.g. where a lease is being surrendered, and the tenant pays a lump sum to cover the surrender premium, arrears and terminal dilapidations but the payment is being classified as terminal dilapidation damages for VAT purposes.

HMRC’s new position gives both landlords and tenants certainty on terminal dilapidations claims and settlements. Landlord’s should continue to ensure they have evidence to support the true “damages” figure (e.g. the cost of repairing the property), particularly where the tenant is paying additional sums such as a surrender premium or arrears.

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