Dilapidations and break penalties – update on VAT treatment

29 January, 2021

In October 2020, we noted that whilst HMRC had reviewed its guidance on the VAT treatment of compensation, damages, penalties and early termination penalties, its commentary on the VAT status of dilapidations payments seemed to be unchanged.  However, that guidance brief has now been withdrawn and the indications are that a new brief will be issued shortly.  So where does that leave us?

 

Earlier this month, HMRC issued internal guidance which initially proposed that certain compensation payments (eg early termination payments and dilapidations payments) would be treated as consideration for the supply of services (thereby attracting VAT) with effect from 1 February. HMRC confirmed this week that the target date has now been pushed back to 1 March and that any changes would not be retrospective (previously they had proposed tracking back to all settlement made during the previous 4 years). 

 

Pending official guidance being issued, the current guidance brief states (rather unhelpfully) that business can choose whether it wishes to treat such payments as consideration attracting VAT or, to treat it as not attracting VAT if it previously treated such fees as outside the scope. In the meantime, we understand that HMRC is obtaining counsel’s opinion so they are presumably expecting a challenge if they decide to treat dilapidations payments as attracting VAT.

 

The basis of HMRC’s case is that such dilapidations payments (made in lieu of the tenant’s failure to comply with the repairing covenants) are simply another part of the consideration paid for the tenant being entitled to occupy the property, in that a landlord would presumably be able to charge a higher rent in the absence of a tenant repairing covenant. This is in line with the way in which ‘wear and tear’ payments have been treated in car hire cases. We will know more about HMRC’s intended approach in the next few weeks.

 

What can we do in the meantime?  There will no doubt be some tenants who are unable to reclaim their VAT who will be pushing hard to get settlement agreements over the line before any changes take effect.  Landlords may choose to apply VAT to the dilapidations payments (and supply a VAT invoice accordingly) in which case tenants will want to include provisions to clawback the VAT if HMRC choose not to treat dilapidations in that way. Either way, it will be important to have clarity on whether a settlement payment is intended to be inclusive or exclusive of VAT. 

 

We will send out a further update as soon as HMRC issue their guidance. In the meantime, please feel free to contact Richard Housley (richard.housley@crippspg.co.uk) or Mike Scott (mike.scott@crippspg.co.uk) if you have any queries.