In September HMRC published new VAT guidance on early termination fees and compensation payments. However, the Revenue & Customs Brief 12 (RCB) has raised more questions than it answers, and the implications for the real estate and construction industries do not appear to have been fully worked out before it was published.

Based on recent EU Meo and Vodafone VAT cases, the RCB effectively changes HMRC's view of the VAT treatment of compensation payments made where a contract terminates early:-

  • HMRC's previous view was that compensation/early termination payments were payments for damages and therefore outside the scope of VAT;
  • the RCB turns this position on its head, so that generally these payments are now subject to VAT;
  • unusually, HMRC says the change in VAT treatment has retrospective effect for the last four years;
  • taxpayers who have failed to charge VAT on transactions in the last four years which are vatable under the new guidance now have to correct the position and pay the VAT to HMRC. Clearly this could leave many people out of pocket.

    A number of representative bodies and other organisations are now in dialogue with HMRC seeking clarity on a range of points and urging HMRC to reconsider whether these changes should be imposed with retrospective effect. It is hoped that HMRC will issue further guidance soon.

    Payments by tenants exercising break rights for early termination of leases

    VAT is now chargeable on payments by tenants to exercise a break clause or where the landlord has otherwise agreed to terminate a lease early, if the landlords have opted to tax. This will be the case regardless of whether the payment is dealt with in the lease or agreement for lease, or is separately agreed between the landlord and tenant. This is one of the few points that is generally agreed to be clear in the new guidance and landlords should make sure that leases/agreements for lease allow VAT to be added to the break payment in these circumstances. The treatment of break payments by landlords is less straightforward and HMRC guidance on that point is awaited.

    Dilapidations payments

    Longstanding HMRC guidance in Land and property (VAT Notice 742) para 10.12 (which has not been amended) confirms that a dilapidations payment "represents a claim for damages by the landlord against the tenant’s ‘want of repair’. The payment involved is not the consideration for a supply for VAT purposes and is outside the scope of VAT." It is reported that HMRC appears to agree that RCB 12/20 does not affect the VAT treatment of dilapidations payments and they still remain outside the scope, but it would be helpful if HMRC could confirm this.

    Liquidated damages

    At first glance the new guidance appears to affect all liquidated damages payments and this caused a lot of concern when the new guidance was first issued. Given the ongoing turbulence in the construction industry caused by COVID-19, many of these payments are being negotiated currently, and if all liquidated damages payments were suddenly subject to VAT this would be a major challenge for the already pressured construction industry.

    Luckily the RCB does not seem to go that far, and HMRC has not amended its longstanding guidance in VAT Notice 708 Buildings and construction paragraph 22 which confirms that "If you receive liquidated damages, you’re not receiving payment for a supply by you and no VAT is due on that amount ".

    Liquidated and ascertained damages

    Close consideration of the RCB guidance suggests that VAT is only chargeable on payments by the customer to the supplier, i.e. by the employer under a building contract to the contractor. If the payment is going in the other direction, for example if a contractor has to pay liquidated and ascertained damages (LADs)to the employer, it is hard to see how this can be additional consideration for the supply of construction services by the contractor under the building contract – the payment is going in the wrong direction. So LADs paid by the contractor to the employer should continue to be outside the scope of VAT. It would be helpful if HMRC could clarify that the new rules only apply to payments by the customer to the supplier, and confirm that payments by the supplier to the customer such as LADs are still outside the scope of VAT.

    Delay and expense claims

    Another unanswered question is whether delay and expense claims, which are paid where there is a delay caused by the employer, are subject to VAT under the new rules? If paid in the course of a continuing contract, they are clearly not payments in connection with early termination/cancellation of a contract, so do they continue to be outside the scope of VAT? HMRC should clarify whether the new rules only apply to payments on early termination of contracts and do not also apply to delay and expense claims paid by the employer to the contractor.

    Retrospective effect

    Having to look back four years and pay VAT on past transactions would cause huge difficulty to the real estate and construction industries at the present time, given the challenges of COVID-19. Taking payments by tenants for breaking leases as an example, in most cases these will have been dealt with on a full and final settlement basis so the possibility of a landlord being able to recover VAT from the tenant is low.

    Landlords cannot be expected to bear the cost of accounting for VAT to HMRC on payments received in the last four years in the current economic climate. In many cases there would be no effect on the Exchequer as tenants would have been able to recover VAT if it had been paid, so surely there should be no requirement to correct in those circumstances anyway. Additionally, there should be no basis on which HMRC can look back earlier than 2018, being the year in which one of the cases HMRC refers to in the RCB (the Meo case) was decided. The changes in the RCB cut across and contradict a lot of other HMRC guidance, and taxpayers have a legitimate expectation that existing VAT guidance could be relied on, so any change should only be prospective.

    There is an urgent need for additional clarification about the extent of this new VAT guidance. HMRC has been incredibly successful in swiftly issuing and updating guidance on the COVID-19 support schemes it has set up and operated, as well as the other HMRC COVID-19 measures to assist taxpayers. HMRC should apply the same standards to addressing the many questions which have been raised by the publication of the RCB so that the position is clear for the real estate and construction industries.

    We understand that HMRC is now considering these points, and in the meantime, will not be taking any proactive actions based on the RCB. Improved guidance will hopefully be issued shortly and HMRC will be persuaded not to make this VAT change retrospectively.


    Isobel d'Inverno

    Director of Corporate Tax