HMRC has now issued draft guidance on its revised view of compensation, liquidated damages and early termination payments and now consider that most of these payments should be treated as further consideration for VAT purposes. Notably this includes dilapidation payments common at the end of commercial property leases, and which will now mostly be treated as additional rent. HMRC has now published draft changes to its internal manuals for comment but now propose that these will be prospective only with effect from 1 February 2021.
The changes follow a number of cases where amounts described as ‘compensation’, contractual penalties or ‘early termination payments’ have been held to be further consideration for supplies of services. However, going forward, it is clear that HMRC’s default position is that a payment from the customer to the supplier is simply further consideration for a supply. Only where no direct link exists between the supply and the payment will the treatment be different.
One of the most significant changes is to the treatment of dilapidations. Typically, a lease of commercial property will require the tenant to return the property in the same state as at the beginning of the lease. In practice, it is rarely practicable for the tenant to do this, and the parties agree an amount as damages.
HMRC now argue that if the lease had provided for reasonable wear and tear, the rent would have been higher to reflect the landlord’s costs of restoring the building to its original state at the end of the lease. Therefore, if a tenant pays dilapidations to meet the same landlord’s remediation costs, this would really further consideration for leasing the building. Therefore such payments will be exempt or standard-rated, subject to the option to tax.
A payment described as a ‘penalty’, ‘damages’ or ‘compensation’ could well have the same treatment as other payments under a contract.
Practical issues
Any early termination charge is likely to have the same VAT treatment as the charges for the main services under the contract. If you are negotiating dilapidations, or any other compensation arrangement, you will need to ensure that the contract is now clear whether these payments are inclusive or exclusive of VAT. If a customer is required to pay a percentage of future charges to terminate early, is it clear whether this is plus VAT?
Howard Ross, Real Estate Partner
Email Howard
t: +44 (0) 7957 209 058