September 16th, 2020 / Insight posted in Articles

Early termination payments and unexpected consequences to the real estate sector

HMRC issued a press release this week on the subject of early termination payments and compensation which may have some unexpected consequences for the property sector.

To date, most early termination payments have been treated as compensation for the loss of future profit, and therefore not subject to VAT. However, following two European Court decisions regarding the VAT treatment of fees paid by mobile phone customers to exit fixed-term contracts, HMRC has now concluded that these early termination fees should be subject to VAT.

While HMRC’s business brief does not mention property, the treatment of early termination payments as subject to VAT raises some challenging questions for the property sector.

UK VAT law has for some time contained provisions which treat so-called reverse surrenders as a supply by the landlord to the tenant, making them either exempt or subject to VAT depending on the existence of an option to tax by the landlord. While this new policy does not seem to upset that treatment, it does raise the spectre of VAT being charged on lease “break payments”, which are specified in the lease rather than negotiated separately between the landlord and the tenant.

It also raises the question as to the correct VAT treatment of other property-related payments made to secure the early termination of long-term contracts. For example, if a new owner of a development were to pay the existing facilities management company a fee to terminate its contract early, this new policy would suggest that that fee is payment for facilities management services and not compensation for loss of income.

Perhaps the most common type of compensation payment seen in the property sector is dilapidation payments, which have long been treated as compensation for tenants’ failure to meet their lease obligations. This new policy does not seem to affect this analysis, as true dilapidation payments stem from the tenants’ failure to maintain the building during the lease.