25 January 2017 #Real Estate
On the surrender of a Lease, it is always necessary to consider whether any VAT will be payable on any payment made by either the Landlord or the Tenant.
There may be some value in the lease, in which case the Landlord may pay the Tenant a premium on the surrender. On the other hand, the Landlord may have no particular wish to take back the Lease and in such a case the Tenant may pay the Landlord to accept the surrender, either because it no longer has any use for the premises or because the premises are overrented. Where the Tenant pays the Landlord, this payment is regarded as a reverse premium.
A surrender by a Tenant of its leasehold interest in return for a payment from the Landlord constitutes a supply by the Tenant to the Landlord. In such a case VAT will be payable on the payment made by the Landlord if the Tenant has exercised an option to tax in respect of the leasehold premises. If the Tenant has not exercised the option to tax, the surrender will be treated as exempt and no VAT will be payable by the Landlord on any premium paid by it.
If the Tenant pays the Landlord to accept a surrender VAT will be payable if the Landlord has exercised the option to tax. Accordingly, if the Tenant pays VAT on its rent and other payments under the Lease, it can be certain that the Landlord has exercised the option to tax and in such a case it will be obliged to pay VAT on the payment made to the Landlord to accept the surrender.
If the option to tax has not been exercised by the Landlord, then the Tenant will not be obliged to pay VAT on any payment that it makes.
Where a Tenant intends to exercise a right to break contained in its Lease and the break clause contains an obligation on the Tenant to make a specified payment to the Landlord, VAT is not usually chargeable on the penalty since HMRC takes a view that if the Lease contains a right for the Tenant to terminate the Lease early on the making of a payment to the Landlord, the Landlord does not make a supply.
However, if the Lease does not contain a break clause but the parties agree after the Lease has been granted to terminate the Lease, then HMRC will treat the agreement as if a supply has been made and VAT will be payable on the payment if the option to tax has been exercised by the party receiving the payment (generally the Landlord).
Compensation for Dilapidations on Termination
When the parties agree to a surrender of the Lease, it is not unusual for the Tenant to make a settlement payment to the Landlord in respect of any outstanding dilapidations liability. When such a payment is made, the Tenant is regarded as paying damages for breach of its repairing covenant and accordingly this payment is regarded as outside the scope of VAT.