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VAT and break clauses - to pay or not to pay?

23 November 2022

A recent decision in the Court of Session has made clear the serious potential pitfalls of not properly considering VAT on the exercise of a break clause. 

Ventgrove Limited v Kuehne+Nagel Limited [2022] (a decision of the Scottish Court of Session (Inner House)) shows the dangers of not properly considering the VAT liability on a break clause.

While the decision is not directly binding in England, Wales or Northern Ireland, it is likely to be highly persuasive as the VAT legislation applies across the UK. At the time of writing, it is not yet known whether the Court of Session's decision will be appealed to the Supreme Court.

Facts of the case

Kuehne+Nagel Limited ("K+N") was the tenant under a 10 year lease from Ventgrove Limited ("VL") with a rent of £450,000. That lease had a tenant break right after the first five years.

K+N wanted to terminate the lease early and so served notice to do so under the break clause. The lease required the payment of £112,500 "together with any VAT properly due thereon". K+N paid the £112,500, but did not pay any VAT.

Following the end of the period for serving the break notice, VL refused to accept the break clause had been exercised correctly on the basis that VAT was due on the break payment and it had not been paid. 

The Court of Session was asked to determine:

1. whether VAT was "properly due" on the break payment; and

2. whether VL had a legitimate expectation that VAT would not be charged on the break payment. 

Was VAT "properly due"?

The Court of Session decided that VAT was properly due on the on the basis that the break payment was payment for a "reverse surrender" (which is a supply by a landlord for VAT purposes). 

As a result, VAT was payable on the break payment if Ventgrove had opted to tax, which it had.

The Court of Session disregarded previous distinctions that had been drawn between a break clause provided for in a lease and a surrender agreed outside the terms of a lease, viewing the economic reality as being the same in both instances. 

The Court of Session saw the ECJ cases that led to HMRC's change of guidance on termination (and similar payments) as relevant, but appeared to consider that the point had actually been determined a long time before those cases were decided.  See our article

In other words, according to the Court of Session, it has always been the case (since at least the mid to late 1990s) that VAT is, as a matter of law, payable on a break payment. 

Did the landlord legitimately expect HMRC to demand VAT on the payment?

K+N sought to rely on previously published HMRC guidance as evidence that VL could have legitimately expected that VAT would not be charged on the break payment (notwithstanding the legal position as determined by the Court of Session).  

The Court of Session stated that, in general, it was not sufficient to point to HMRC guidance to establish an expectation that incorrect VAT analysis (by HMRC) would trump the statutory provisions. An erroneous view of the law, even by HMRC, is not enough to create the presumption that taxpayers can legitimately expect to be taxed on an incorrect basis. 

The Court of Session went on to find that, in any event:

1. the ECJ decisions (on which HMRC's revised policy had been based) had made clear (in 2017 and 2019) that HMRC's previous guidance had been wrong; and
 
2. HMRC's guidance on "reverse surrenders" had not included reference to any distinction between break payments and surrenders outside the terms of a lease.

Key points to note

Ventgrove Limited v Kuehne+Nagel Limited [2022] clearly reaffirms the importance of considering break clause provisions in detail when looking at the exercise a break option in a lease. 

This decision follows a number of non-tax decisions that also make this plain (as small administrative failures can be sufficient to render a break notice invalid).

In particular, the decision makes clear the importance of considering the VAT position in such circumstances and, in cases of uncertainty, possibly paying VAT in the first instance to prevent later arguments about invalid break clause exercise.

Finally, the decision of the Court of Sessions underscores the importance of drafting break clauses appropriately and factoring VAT (including VAT invoicing requirements) into the drafting.

The tax team at DWF has significant experience in advising on a wide variety of real estate sector matters, including large developments and forward funding arrangements, real estate financing, investment property acquisitions and restructuring and complex lease arrangements.

Please contact one of our experts if you would like to discuss the implications of the decision discussed above.

Further Reading