HMRC Finally Clarify VAT Treatment on Terminal Dilapidations Damages

Termination fees and compensation payments

On 7th February 2022, HMRC published Revenue & Customs Brief 2 (2022), which is its updated guidance on early termination fees and compensation payments.

Prior to 2020, HMRC guidance stated that when tenants paid sums to withdraw from agreements to receive goods or services, those payments were outside the scope of VAT.

In September 2020, HMRC published Revenue & Customs Brief 12 (2020), stating that those payments would be subject to VAT with retrospective effect. Regardless of whether the payments were correctly described as compensation or damages, that was their position.

As a result of the September 2020 brief terminal dilapidations payments, which were genuine damage payments were, therefore, subject to VAT. That position would, however, be short-lived.

Revisiting the brief

Following some constructive feedback, four months later, in January 2021, HMRC announced that it was revisiting its September 2020 brief, and it said that the retrospective effect element of the September 2020 brief was now dropped.

On 7th February 2022, HMRC set out its new position, and it re-confirms the general position that:

“early termination fees payable in respect of a contract will usually be treated as further consideration for the underlying supply as provided for in that contract.”

In short, had the contract not been terminated, if VAT would have been due on the sums which are being paid, then VAT will be payable on the sums.  

This will be the case when the original contract allows for such an early termination (e.g. exercising a break option) or when a separate agreement is reached to bring the contract to an end (e.g. deed of surrender), and this is the effect even if the payment is described as damages.

So, if a tenant is to make a “bullet payment” under the break clause, the tenant will be required to pay VAT on that payment where the landlord has opted to tax.

Terminal dilapidations payments

HMRC, in its February 2022 brief, confirms that terminal dilapidations payments (i.e. the genuine payment made by the tenant to the landlord for breaches of the tenant’s repair covenant contained in the lease) are outside of the scope of VAT and so genuine terminal dilapidation damages payments will not attract VAT. 

HMRC have repeated the comments it first made in January 2021 that it may depart from this new position if, in individual cases, it finds evidence of “value shifting” from rent to dilapidations payments to avoid accounting for VAT, e.g. where a lease is being surrendered, and the tenant pays a lump sum to cover the surrender premium, arrears and terminal dilapidations but the payment is being classified as terminal dilapidation damages for VAT purposes.

HMRC’s new position gives both landlords and tenants certainty on terminal dilapidations claims and settlements. As per our previous note, landlords should continue to ensure it has evidence to support the true “damages” figure (e.g. the cost of repairing the property), particularly where the tenant is paying additional sums such as a surrender premium or arrears.

Here to help

If you have any more questions or would like more information regarding these recent changes, you can contact our Property Litigation Team below.