The impact of the COVID-19 pandemic has resulted in many concessions to, and terminations of, various contractual agreements, particularly lease agreements and contracts for goods and services. The VAT treatment of both arrangements is complex, and HMRC has made recent announcements in relation to both. While HMRC’s clarification of the VAT treatment of some barter transactions between landlords and tenants is helpful, its (potentially retrospective) change to the VAT treatment of contract termination and compensation payments is surprising, especially in the current circumstances.
VAT and lease variations
As many tenants have faced financial difficulty as a result of the pandemic, landlords have agreed to vary the terms of existing leases with tenants paying no additional rent in return for such variations. These are termed “barter” transactions if any non-monetary consideration is given for the variation, and could potentially be subject to VAT.
HMRC helpfully clarified in guidance issued on 29 July 2020 that certain lease variations will not constitute barter transactions and will therefore be outside the scope of VAT. If a landlord and tenant agree to a rent concession, such as a rent-free period or a period of reduced rent, and the tenant does nothing in exchange for the concession, no supply will have taken place for VAT purposes. HMRC has also clarified that a tenant does not make a supply to a landlord for VAT purposes simply by agreeing to an extended lease or to the variation of a break clause, provided that the tenant has only agreed to pay rent for a longer period and has not, for example, agreed to carry out works on behalf of the landlord.
While the clarification by HMRC is helpful and welcome, the guidance does not cover all possible lease variations – for example a variation in which a landlord agrees to a rent-free period in return for the tenant carrying out works to the property – and there are many other examples of property barter transactions where the VAT situation is less clear. If the parties’ specific situation does not fall within HMRC’s guidance, they must consider the VAT implications on both sides of the barter transaction carefully, and clearly document the agreed consideration for any transaction.
Contract termination and compensation payments
The pandemic has also resulted in many more contract terminations, and also the settlement of disputes that would otherwise go to court. HMRC has recently changed its practice in relation to such payments, announcing on 2 September 2020 that VAT will be payable on most early contract termination and settlement payments.
Prior to HMRC’s announcement, the guidance was that when customers were charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT. This was because compensation for breach of contract was regarded as compensating for loss of profit. Similarly, damages calculated according to provisions in a contract, such as liquidated damages commonly found in construction contracts, were also considered outside the scope of VAT as they were compensation for loss of earnings.
Unfortunately, HMRC has now reversed this guidance and the presumption should now be that most compensation payments are subject to VAT unless an exception applies. Exceptions will only be applicable “where there is no direct link between a payment and a supply of goods or services”, or where damages are not envisaged under the contract itself.
HMRC’s new position is unhelpful, particularly in the current climate, as it will involve parties needing to come up with an additional 20% of cash to cover the VAT liability at a time when additional cash is difficult to find. In its announcement, HMRC also stated that businesses that have failed to account for VAT on such payments should correct the error. However, the announcement did not state how far back HMRC is expecting businesses to look in order to correct their past payments. HMRC has tended to apply changes such as these prospectively and so it is unclear why these specific changes have been applied retrospectively.
Practitioners are urging HMRC to reconsider the retrospective element of the changes so that they, at least, only apply from the date of HMRC’s announcement. In any event, it could be argued that taxpayers had a legitimate expectation that HMRC would follow its published guidance and therefore they should not be required to revisit past treatment in accordance with that guidance.
Christine Yuill, partner, and Zita Dempsey, solicitor, Pinsent Masons LLP