Property and VAT: The ground shifts again

HMRC’s recent announcement (RCB 2/22) of a revised policy on the VAT treatment of early termination fees and compensation payments will be relevant to you if you advise clients:

• in the property sector, in particular landlords or tenants; or>
• who enter into commercial (e.g. supply or construction) contracts.>

The change in policy applies (meaning all businesses must follow it) from 1 April 2022, and HMRC’s VAT manual has been updated. HMRC’s attempts at clarifying the VAT treatment of termination and compensation payments (whether or not outside the scope of VAT) have caused confusion since it announced a new policy in September 2020 (in RCB 12/20), before suspending that in January 2021. Following input from the professions and property industry bodies, HMRC’s views have evolved.

HMRC’s current view

The guidance introduced by RCB 2/22 is long on deliberation (discussion of case law and possible arguments either way), but short on practical examples, especially with respect to the property sector. This note sets out some practical examples.

The general idea behind HMRC’s new policy is to treat payments made to terminate a contract as VATable if there is a “direct link” to be found to a past VATable supply (on the basis that it is further consideration for that supply). HMRC says (at VATSC05910): “the question will be, why isn’t other income it has received in connection with that supply also within the scope of VAT?” The past concept, familiar to many practitioners, that if a payment can be said to be compensation it is not VATable should no longer be assumed to hold good without considering whether the payment forms part of the (broadly construed) price for the supply.

The overall theory behind the policy makes sense in many cases. For example, on a mobile phone contract where the amount payable to cancel is the same amount as the total of the amounts due each month for the minimum term, less the months already paid, it is easy to see how this amount could be seen as an amount related to the acquisition of the services – as it is an amount the customer must pay in order to have the right to have services supplied for a period (even if in the end they choose to cancel and not use the services for the full period). Note that this same point applies even where the amount to be paid to terminate does not exactly match what would otherwise have been paid across the term. This is because the supplier has contracted to get at least this minimum return for supplying the services/providing a right to have the services supplied for a period.

However, not all payments are further consideration for supplies made. HMRC gives an example of car hire, and payments made by a hirer because they have crashed the car. While these are “linked to” the supply of the car, they are not further consideration for the hire. Rather, the payment is because of an unexpected event and the supplier does not provide (or have an obligation to provide) anything for the extra payment made. Similarly, fines and penalties which are set at a level designed to be punitive (as opposed to being simply an additional, higher, charge in return for a continuing or further supply) are not VATable.

VAT on certain typical property transactions

The new guidance only expressly covers dilapidation payments. We have set out below what we consider to be the likely position HMRC would take, based on the principles behind the new policy.

Dilapidation payments at the end of a lease. These are outside the scope of VAT (unless linked to lower rentals, which would be difficult to establish). HMRC accepts such payments are for damage to the property “rather than for use of the premises and would be beyond what the landlord agreed the tenant could use the premises for”. Note that VAT Notice 742 has not been updated with any qualification around lower rentals. If HMRC intends this qualification to be a serious consideration, it would be useful for there to be a link from VAT Notice 742 to this new guidance, as many property lawyers may only look to that notice.

Break rights. These will be VATable (assuming the landlord has opted to tax the property). Previously, this would have been considered outside the scope if a break clause was included in the lease[1]. Now, HMRC would likely consider the payment to the landlord to be part of the overall payments for the supply of the premises and so subject to VAT if the rent was. It is possible that an alternative argument could be made if there were no correlation between the break right payment amount and the landlord’s expected return, but it is unlikely HMRC would accept this.

The case of Ventgrove v Kuhne & Nagel [2021] CSOH 129, a Court of Session case, provides some support for an argument here. It was decided in late December 2021 while HMRC was in limbo over its (suspended) 2020 RCB. The case involved a lease at the end of its minimum period and a sum had been paid to the landlord, in accordance with the lease’s terms, to end it. The question was whether the lease had been validly terminated and this turned on whether VAT was due on that payment (because if so it would also have been required to be paid to the landlord in order to terminate the lease).

The court held VAT had not been due; it noted that HMRC had not (given the suspension of the RCB) changed its policy that VAT was not due where a break right was built into the lease, nor had there been any relevant case law deciding otherwise. The court noted (at para 21) that the two EU cases relating to compensation for termination/cancellation of minimum term phone contracts (which had precipitated HMRC’s RCB) were not directly in point; here, the minimum term in the lease had been exceeded, the rent did “not correspond to the amount of rent that the landlord would have received had the lease run for its full term of 10 years”, nor was this a payment of an amount calculated by reference to costs for the supplier of a failure to comply with a tie-in period. However, this case is under appeal at present.

Reverse surrenders (a payment to landlord for it to accept the surrender). These are, as before, seen as a VATable supply by the landlord (assuming the landlord had opted or the property was new for VAT purposes).

Deposits (held pending completion of a property sale). It is likely that these would be treated by HMRC as VATable, as a type of cancellation/termination payment. HMRC announced a change of position on deposits for “no shows” (e.g. where a hotel room is booked but the individual does not use it and the supplier retains payment made in advance), with effect from 1 March 2019 (RCB 13/18). Prior to that, these were treated as compensation so outside the scope.

The alternative argument to the position HMRC would likely take is that the forfeiture of a deposit is a payment to discourage default rather than to compensate a supplier for lost income, meaning it should not be classed as VATable. A distinction that can be made in the case of a deposit, as opposed to other termination payments, is that there is no other supply made to which the deposit can be linked. A distinction could also be made between “no show” payments (e.g. where the price of a stay in a hotel room is forfeited) and deposits on a property sale – a would-be property purchaser is promising to perform an agreement to buy a property and the deposit acts as a disincentive to fail to perform (i.e. a penalty), which is different to paying for goods or services which you then choose not to use. In retaining the deposit on a property sale, the would-be supplier is not ensuring they get a certain economic return on a supply – this can be seen in the fact that the deposit is only a fraction of the completion price. However, it is considered unlikely HMRC would accept this argument (as it effectively rejected this in its 2019 change regarding “no shows”).

Practical tips

Clarity and (where necessary) apportionment. As always with VAT, it will be important to document how much is being paid and for what. This will be especially important in property situations where a tenant is unable to recover VAT charged to it. For example, we know that HMRC has accepted that dilapidations payments (generally) continue to be outside the scope of VAT. However, other payments such as break payments may not be. For a tenant exiting a lease, this means it will be important that it documents the amounts paid to its landlord and what each element is paid for, and resists calls to simply pay one lump sum which does not identify the various components that lie behind it. Without a reasonable apportionment, the risk is HMRC will seek VAT on the entire amount.

Deposits. On a contract being entered into and a deposit collected, the VAT amount on the deposit should be collected and held too (by, usually, the stakeholder). If the sale fails to complete, the would-be seller will be required to issue a VAT invoice to the would-be buyer for the forfeited deposit, and to account for the VAT in their next VAT return. Previously, VAT would have been requested with a deposit in most cases anyway (on the basis that the transaction itself was expected to be VATable when it completed), but there may have been cases where it was not collected until the transaction completed. Now in these instances, if the outcome is forfeiture of a deposit there will be a need to charge VAT (at least if following the likely HMRC view outlined above), and collecting this from the (no-longer) purchaser may prove more difficult than it would have been at the time the deposit was paid; it would be wise to collect it upfront.

Contracts. Consider VAT provisions in new contracts (and existing ones before making any new types of payments) – suppliers should ensure they have an ability to charge VAT to the customer (and not end up funding the VAT themselves). Any drafted on a “VAT inclusive” basis or silent on VAT will not allow this.

[1] HMRC’s previous policy that if a break clause had been included in the lease, the payment under it was not VATable, was recorded in the arguments in Lloyds Bank plc (LON/95/2525). In Lloyds, no break clause had been included in the lease so HMRC argued, successfully, that VAT was due (as the landlord had opted) on the grant of the right to break.