Tenants take note: dilapidations damages to be subject to VAT

Those who 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.

Because 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 that is about to change.

HMRC has 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.

With less than two weeks to go, it is therefore imperative that you make it clear whether any dilapidations damages settlement you’re currently negotiating is inclusive of VAT.

The good news is that HMRC do not intend to make the new rules retrospective, so any old dilapidations settlement agreements do not need to be revisited.

HMRC has invited comments on these changes, but with such a short timeframe before they come into effect, it is likely that the new rules will be in force as drafted from 1 February 2021 regardless.  Whether they might be amended subsequently remains unclear.

This change could be unwelcome news for those tenants where they cannot recover VAT themselves (such as those who are VAT exempt).

In all cases, it would be wise for a landlord 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.  If it is clear that VAT has already been accounted for in the settlement sum, the settlement sum should be expressed as inclusive of VAT and the tenant should seek to ensure that the agreement is in full and final settlement of the claim, including any applicable VAT.

If you are affected by this change, please do not hesitate to get in touch with a member of the team.