Those that regularly let commercial premises will be aware that landlords are usually able to claim damages for dilapidations arising from breaches of a tenant’s covenants relating to the physical state of the building at the end of the lease.
As the payment of damages represents compensation for the tenant’s failure to comply with their lease obligations, such payments have historically been outside the scope of VAT. However, this is about to change.
HMRC have confirmed that they intend to treat dilapidations payments as being subject to VAT (if the landlord has opted to tax) from 1 February 2021. HMRC’s view appears to be that since dilapidations payments are provided for in the lease, they represent an additional consideration payable by the tenant under the lease and should therefore be subject to VAT.
HMRC’s change of approach follows two European Court of Justice decisions that contractual payments made by customers on the early termination of their fixed term contracts constituted consideration for the supply of the services for which the customers contracted, rather than compensation for the breach.
It is therefore necessary for landlords to take action when agreeing dilapidations settlements to ensure that they expressly reserve the right for landlords to recover VAT in the eveNt that HMRC determine that they are subject to VAT.
Whilst this may be viewed as detrimental to tenants, it is unlikely that HMRC will make the new rules retrospective and thus, any old dilapidations damages settlement agreements will not need to be revisited.
HMRC have welcomed comments on this change, however, with such a short timeframe until the new rules are enforced, it remains unclear as to whether any such amendments shall be made prior to the 1 February 2021.
In all cases, it would be wise for landlords in any dilapidations settlement agreement to state whether the sums due are inclusive or exclusive of VAT, and include an express provision requiring the tenant to pay VAT on any damages in the event that HMRC find that such a payment is subject to VAT.