VAT treatment of termination payments, including break fees

HMRC have (finally!) published their long awaited guidance on the VAT treatment of early termination fees (including break fees) and compensation payments. This states that the majority of early termination/cancellation fees are liable to VAT if the underlying goods/services to which the fee relates are subject to VAT. This means that if a Landlord has opted to tax a property, any fee payable by the tenant to break the lease early will be subject to VAT. This is a U-turn from HMRC’s original guidance which stated that payments arising from early termination of an agreement were generally outside the scope of VAT.

The rationale for this change is that termination fees should be viewed as further consideration for the underlying supply under the agreement. This is the case regardless of whether or not the right to terminate is included within the original agreement.

There are some exceptions to this general rule, so some payments made on termination of an agreement may still be outside the scope of VAT, including:

1. ‘Punitive’ and substantial termination fees designed to deter a breach of the contract. The guidance suggests that the level of the termination fee as compared to the amounts otherwise due under the contract should be indicative of whether the fee is punitive (and therefore outside the scope of VAT) or whether it is indeed further consideration for the underlying supply (and therefore subject to VAT). In the context of leases, it is unlikely in practice that a break fee will be higher than the remaining rent due under the lease so this exemption is unlikely to apply.

2. Charges for “unexpected events” as opposed to “common occurrences”. The example in HMRC’s guidance in respect of this distinction relates to a car hire contract – writing off the car would be an unexpected event so any amount payable by the hirer as a consequence would be outside the scope of VAT. However, returning the car late would be a common occurrence and so fees for late returns will be subject to VAT. Again, in the context of lease break fees, it is difficult to see how this exemption would apply in practice.

3. Liquidated damages/compensation payments made by a supplier to customer (ie. to compensate the customer for loss suffered as a result of a breach by the supplier). Such payments should continue to be outside the scope of VAT on the basis that they do not represent consideration for a supply made by the customer under the contract. The VAT treatment of break fees or surrender payments paid from a Landlord to a Tenant (ie. a reverse surrender/break) are therefore not affected by this updated guidance and so will need to be considered on their facts in accordance with the pre-existing rules.

4. Dilapidation payments due on termination of a lease. HMRC’s manual sets out the arguments on both sides in relation to the VAT treatment of dilapidation payments but concludes that, having weighed up the factors, unlike break fees, dilapidation payments should not be treated as further consideration for the supply of a lease and will therefore be outside the scope of VAT. However, HMRC may depart from that view in cases where there is evidence of value shifting from rent or break fees to dilapidation payments in order to avoid accounting for VAT. Advisors should therefore be alive to any arrangements where it appears that a dilapidations payment is increased and rent or break fees are reduced.

All businesses must adopt the revised treatment no later than 1 April 2022. Any businesses that adopted the ‘optional’ treatment outlined in the previous interim guidance issued in January 2021 and so accounted for VAT on transactions which under the new guidance are outside the scope may amend their VAT return if they wish.