Until recently, the default position was that compensation payments were outside the scope of VAT. However, recent guidance from HMRC has changed this position.
Recent consideration by the UK courts and the European Court of Justice of compensation payments has resulted in a change in the approach to their VAT status. HMRC have since released guidance supporting this change meaning that compensation payments are now generally liable to VAT. The guidance was published in HMRC’s Business Brief 12/20 (2 September 2020).
The Former Position
The former default position was that compensation payments were outside the scope of VAT as they were not consideration for a supply. In practice this meant that where a lease contained a compensation provision, for example where a compensation payment arises for early termination, the payment would not be subject to VAT (unless an option to tax has been made by the party receiving the payment).
If you would like to find out more about VAT, Commercial Property and the Option to Tax, please take a look at this article: https://www.herrington-carmichael.com/vat-commercial-property/.
The ‘New’ Position
The new guidance from HMRC makes it clear that compensation payments (or payments described as ‘compensation or damages’) are now generally liable to VAT. In practice, this now means that a compensation, early termination and/or cancellation payment may be considered a payment for a supply and, if so, will be liable for VAT.
Rather unusually, HMRC’s guidance also advises that the new position will be retrospective. Therefore, a VATable person who has received a compensation payment prior to the release of the above mentioned guidance must also account to HMRC for the VAT as soon as possible.
It is important to note that the new approach will not only affect new Leases as it applies where the compensation clause has been exercised. So, if, for example, a lease was dated 10 years ago but the compensation clause was only exercised 2 years ago, the compensation payment would now be potentially subject to VAT.
HMRC does acknowledge that some compensation payments may be true compensation and not payments for supply and therefore will be outside the scope of VAT. In practice this means that when entering into a new lease containing compensation payments, it is now particularly important that the drafting of such compensation clauses clearly reflect the intention of the parties.
In the Real Estate and Construction sector, HMRC’s guidance should be considered carefully in the context of the following types of payments:
• Break payments under leases (whether contained in the lease or otherwise);
• Forfeited contractual deposits;
• Dilapidations payments; and
• Liquidated damages payable pursuant to development agreements and agreements for lease.
Next Steps
If you have received or made compensation payments under your lease within the last 4 years, we advise that you seek specific advice on the VAT status of that payment.
If you require further advice regarding compensation payments and VAT or any other Real Estate matter, please contact Daniel York in our Real Estate department. You can also email your query to realestate@herrington-carmichael.com, call 01276 686222 or submit an online enquiry form.
This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to a particular matter
