Despite HMRC’s recent clarification that VAT does not apply to dilapidations, there are instances where an allowance for compensation in lieu of VAT can legitimately be included in a claim.
Dilapidations are outside the scope of VAT as far as HM Revenue & Customs are concerned. This has become clear in recent months despite the uncertainty created by HMRC last year (see our previous article).
HMRC make the position clear in section 10.12 of Land and property (VAT Notice 742), as follows:
‘A dilapidations payment represents a claim for damages by the landlord against the tenant’s ‘want of repair’. The payment involved is not the consideration for a supply for VAT purposes and is outside the scope of VAT’
So there you have it, VAT need not feature in dilapidations claims and settlement agreements.
If only it were that simple…..
When does VAT apply to Dilapidations?
HMRC’s position on VAT in dilapidations claims is that it is a payment in settlement of damages. It is not ‘consideration’ in return for a ‘supply’ and is therfore outside the scope of VAT.
This makes eminent sense. A tenant paying the Landlord an agreed sum for having failed to return the property in the condition they had covenanted to under contract is not paying the Landlord in return for a supply of goods and services. This is irrespective of the ‘elected’ VAT status of the Building (set out in more detail below).
So when does VAT apply to dilapidations claims? Whilst VAT never actually applies to dilapidations, in reality there are situations where an allowance for VAT can be included in the settlement figure. This is known as ‘compensation in lieu of VAT’.
This principle can be applied where the Landlord is genuinely at risk of suffering an otherwise irrecoverable loss of the value of VAT on any work he undertakes through the tenant’s default. This will of course depend on the elected VAT status of the building.
VAT Status – The Building
Firstly it is important to consider the VAT status of the subject building. Landlords have the option to keep the building exempt from VAT (also referred to as ‘unelected’). Alternatively, they can waive this exemption and ‘elect’ the building for VAT (otherwise known as ‘opting to tax’).
The tenant will know the VAT status of the building from the outset since they will either pay VAT on their rent or not. This is the simplest way surveyors negotiating dilapidations settlements can deduce the VAT status of the building.
Building Unelected for VAT
Where the Landlord has retained the exemption from VAT and assuming the tenant failed to deal with any dilapidations works prior to lease expiry, then the Landlord may wish to undertake the necessary works.
On the basis the building is exempt from VAT, any VAT the Landlord incurs on materials and labour in undertaking such work will effectively be lost as it cannot be reclaimed from HMRC.
This loss needs to be addressed. Otherwise the Landlord will have incurred an additional expense resulting from the tenant’s failure to observe their repairing obligations.
The value of this loss (20% of the cost of material & labour) can then be recovered from the tenant within the dilapidations settlement as ‘compensation in lieu of VAT’.
Building Elected for VAT
If the Landlord has waived the exemption from VAT, and has been charging VAT on the rent, then he will be in a position to offset or reclaim VAT on any subsequent works expenditure.
No loss will have been incurred for the cost of VAT on the works the tenant ought to have undertaken. As such, ‘compensation in lieu of VAT’ cannot be added to the dilapidations claim as an irrecoverable loss.
Will work actually be done to remedy the Dilapidations?
Whether works to remedy the dilapidations claim have been done, may be done or are unlikely to ever be done are all important considerations.
It stands to reason that if the Landlord has absolutely no intention of undertaking any such works, then there will be no loss incurred in the form of VAT. In such instances it should be excluded from any dilapidations claim (See Elite Investments v TI Bainbridge Silencers Ltd (No.2)).
It is worth noting that the burden of proof of the Landlord’s intention to carry out works will fall on the tenant, until the passage of time speaks for itself.
On the other hand, if the Landlord is able to demonstrate a genuine intention to undertake the works, or has already carried them out, then the additional claim for compensation of VAT on top of damages for the cost of works is likely to be enforceable as a legitimate loss. (See Drummond v S & U Stores  and Sun Life Assurance Plc v Thales Tracs Ltd ).
The treatment of VAT in dilapidations claims is not a straightforward matter and warrants detailed consideration.
In order to legitimately claim for ‘compensation in lieu of VAT’, it is necessary to consider the elected status of the building. It is also important to understand whether or not the works are likely to be done or not. In this regard it is important to bear in mind the principle in all dilapidations claims; the Landlord cannot properly make a claim for what he has not lost.
For any further help or advice, please call our Enquiry Line on 020 4534 3132, or contact a member of the team direct, details below:
BSc (Hons) MRICS