In September, HMRC issued its Revenue and Customs Brief 12 (2020). This set out HMRC's new policy concerning VAT on compensation, liquidated damages and similar payments related to the termination of agreements. HMRC's change of approach was inspired by recent judgements of Court of Justice of the European Union ("CJEU").
Broadly, HMRC now views most compensation, liquidated damages and similar payments made in respect of the termination of an agreement (whether these payments are made under the terms of an existing contract or agreed separately) as being consideration for a supply for VAT purposes (and so potentially subject to VAT).
While the CJEU cases that inspire HMRC's new policy had nothing to do with the real estate sector – the most recent case concerned termination payments made under mobile phone contracts – the scope of HMRC's revised policy means that the real estate sector cannot afford to ignore it.
This is an evolving area (and further guidance from HMRC is anticipated). However, below we have set out a couple of the key implications which are of relevance to the real estate sector.
Break Clauses and Similar Lease Terminations
It is common for leases to include terms allowing one party to end the lease, subject to paying compensation, liquidated damages or a fee. For example, a hotel operator may exercise a tenant break clause to end an existing lease where the hotel is no longer profitable.
Historically, such payments were regarded as outside the scope of VAT where their payment was governed by the terms of an existing lease, as in the case of break clauses.
One implication of HMRC's change of policy is that break payments made by a landlord or tenant should effectively be treated the same as a payment for a surrender of a lease – i.e. in most cases, VAT will be chargeable if the party receiving payment has opted to charge VAT in respect of the property.
The implication of HMRC's change in views extends even wider than this and would very likely encompass situations where a tenant exits its lease early in breach of its lease and is required to pay damages to its landlord for that breach.
Further clarification is awaited from HMRC as to exactly which payments made under or in respect of leases now qualify as VATable payments. However, for the time being it is advised that landlords and tenants seek tax advice in relation to any payments made in relation to a change of lease terms or the ending of a lease.
Property Managers and Developers
HMRC's change of approach has more straightforward (but still important) implications for property managers and developers (and their contractual counterparts).
Development and property management agreements may include provisions allowing one party to terminate the agreement, subject to compensating the other party. Development agreement may also include step-in rights, subject to similar compensation. Our understanding of HMRC's new approach, is that any such payments will likely be subject to VAT. HMRC's confirmation is awaited and tax advice should be sought in each case.
As a result, those involved in property management or development should seek tax advice where it appears that they may make or receive a payment in relation to the ending of an agreement. Further, property managers and developers should consider the implications of HMRC's new policy when negotiating new contracts and ensure that they have the ability to charge VAT in cases where payment is received in relation to the agreement ending.
Key Areas of Uncertainty
The consequences of HMRC's new policy for those in the real estate sector is still unclear in some areas. A particularly relevant point of uncertainty is in the case of dilapidation payments made by an outgoing tenant to a landlord.
HMRC's guidance before its recent change of policy was that such dilapidation payments were generally outside the scope of VAT as being purely compensation and not consideration for a supply. However, it is not yet clear whether this remains HMRC's view – although at the time of writing, it is understood that HMRC has confirmed to at least one industry group that their position on dilapidations has not changed.
It is hoped that updated guidance will make the VAT treatment of dilapidations clearer.
Interest on Late Payments
It is common for landlords to charge interest on late payments made by tenants. Unfortunately, HMRC's change in policy makes the VAT treatment of these interest payments uncertain. In our opinion, and that of the British Property Federation, VAT should not be payable in respect of genuine late interest payments. However, again, at the time of writing, this is not been clearly confirmed by HMRC.
It is important to note that HMRC has said that its policy will have retrospective effect. Therefore, it is vital not just to consider the future implications of HMRC's new policy, but to consider how it may impact events that have already happened. Indeed, the VAT treatment of events up to four years in the past (or more in certain cases) may be effected.
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 HMRC's change of policy on VAT and termination payments.