How did we get here?
Historically, HMRC treated dilapidation payments as compensation payments made by tenants for damages arising from the tenant's want of repair, with the result that such payments were not withing the scope of VAT.
However, in September 2020, HMRC issued guidance which suggested that its view of termination payments (which probably included dilapidation payments) had changed, and payments could be subject to VAT. HMRC said it intended to apply this new treatment retrospectively, which caused uncertainty and concern in the sector.
In December 2020, following pressure from industry, HMRC agreed to review its position and confirmed that in the meantime, taxpayers could continue to treat these payments as compensation and outside the scope of VAT.
What does the new guidance say?
HMRC has now published its long awaited updated guidance in the form of Revenue and Customs Brief 2 (2022).
The new guidance centres on the VAT treatment of payments for terminating contracts generally, rather than specifically dilapidation payments.
The main point made by the new guidance is that, as a general rule, from 1 April 2022, fees charged when customers terminate a contract early will be regarded as further consideration for the contracted supply, and, if VAT is chargeable on the other consideration given for that supply, will be subject to VAT.
What about dilapidation payments?
HMRC acknowledges that dilapidation payments is a difficult area and understands that dilapidation payments broadly exist to ensure landlords are not out of pocket if property is not returned in the agreed condition at the end of a lease.
In carefully reasoned guidance, contained in its internal VAT manual, HMRC's general position (from 1 April 2022) is not to treat dilapidation payments as further consideration for the supply of a lease, meaning that in general, dilapidation payments should not be subject to VAT.
This is not a hard and fast rule, and it is always worth taking specialised advice on the VAT implications both at the stage where the lease is drafted and on termination of the lease. In particular, HMRC will be looking out for cases of value shifting between rent (or premium) and dilapidation payments.
Parties to the lease which is being surrendered are advised to keep clear records of what dilapidation payments consist of and how they have been calculated.
Landlords and tenants should ensure that, on a lease termination, any payment in respect of dilapidations is documented and calculated separately from any other payment being made (such as a surrender premium).
Further, landlords entering into new leases should consider reserving the right to recover VAT from dilapidation payments so as to provide some protection in the event that HMRC determines that VAT should have been charged on some or all of the dilapidations payment. Tenants should also remain mindful of their liabilities in such circumstances.