Update: Change in VAT treatment of break penalties/early termination fees
VAT is rarely a property lawyers (or indeed anyone’s?) favourite topic. But it has a habit of laying traps so it does pay to keep on top of it.
Until recently, HMRC guidance drew a distinction between (1) payments made where there was no pre agreed right to terminate in the contract (which it viewed as payments for the supply of land and potentially within the scope of VAT), and (2) circumstances in which one party had a pre-agreed right in return for making a specified payment to the other (which it viewed as not being a supply, and therefore outside the scope of VAT).
However, following two recent judgments issued by the Court of Justice for the European Union (insert links) relating to non-Real Estate contracts, HMRC has changed that guidance to remove this distinction (Link to Guidance Notice). This revised guidance confirms that, provided there is a direct link between the payment and the supply, payments (whether described as penalties, compensation or damages etc) made for the early termination of contracts are usually to be regarded as consideration in return for a supply. This will therefore depend on the facts of the situation, but HMRC considers that it is likely that these payments, including “break penalties” will now generally fall within the scope of VAT. Whether or not VAT is payable on top of the “penalty” will depend on whether or not the party which is receiving the payment has opted to tax.
This of course contrasts with how dilapidations payments have been viewed. These payments have been (and it seems to us would continue to be) regarded as damages / compensation paid to the landlord for a tenant’s breach of covenants. On that basis, dilapidations payment would therefore still not be within the scope of VAT
The Guidance Note comments very briefly that it falls to recipients of such payments to account for VAT if they have failed to do so. This indicates that HMRC regards this change as having retrospective effective, although no comment is provided as to how far back these recipients should look. Businesses should therefore consider their obligations carefully in this regard.”