VAT and Dilapidations : Detailed Guide

When it comes to commercial property leases, the subject of VAT and dilapidations is a crucial but often misunderstood area.

In this article, we explore in detail the treatment of VAT in dilapidations claims, tracing recent changes and clarifications from HMRC, and what this means for landlords and tenants today.

Understanding VAT and Dilapidations

"Dilapidations" refer to breaches of a tenant's lease obligations relating to the condition of the property. Typically, at the end of a lease, a landlord may make a dilapidations claim to recover the cost of repairs if the tenant has failed to keep the property in the required state of repair.

The relationship between VAT and dilapidations, however, has long been complex. Is VAT chargeable on dilapidations payments? For years, the answer seemed relatively straightforward: such payments were treated as compensation, outside the scope of VAT. However, developments over the last few years have muddied the waters and prompted renewed guidance from HMRC.

HMRC's Revenue and Customs Brief 12 (2020)

In September 2020, HMRC released Revenue and Customs Brief 12 (2020). This brief outlined proposed changes to the VAT treatment of compensation and similar payments, following judgements from the Court of Justice of the European Union (CJEU).

The brief suggested that any payment from a customer to a supplier, even if described as compensation, could actually represent further consideration for the original supply. As a result, if the original supply was subject to VAT, the "compensation" payment would also be subject to VAT.

Although the brief did not explicitly mention VAT and dilapidations, the implications were significant.

The principles set out suggested that dilapidations payments could, in certain cases, be seen as further consideration under the lease agreement. Consequently, if a lease was opted to tax (i.e., VAT applied to rents and related payments), then dilapidations payments might also attract VAT.

This position generated considerable confusion and concern among landlords, tenants, and legal advisers. If VAT applied to dilapidations payments, it would potentially increase costs for tenants by 20% and complicate negotiations and settlements.

VAT and Dilapidations : Industry Reaction and Uncertainty

Following the brief's release, industry bodies, property professionals, and legal commentators raised significant concerns. The possibility that VAT could apply to dilapidations payments in most cases was seen as an unwelcome departure from established practice.

Many questioned whether HMRC's interpretation aligned with the underlying legal principles of damages. After all, dilapidations payments are intended to compensate the landlord for loss caused by the tenant's breach of contract, rather than being payment for any specific service or supply.

The need for clarification became increasingly urgent as businesses sought certainty during lease negotiations and exit strategies. This was particularly important against the challenging economic backdrop of the COVID-19 pandemic.

HMRC’s Revised Approach in 2021

Thankfully, HMRC listened to industry concerns and revised its stance. In January 2021, HMRC announced that it would rethink its position and issue further guidance on VAT and dilapidations.

Until the promised guidance was available, businesses were given two options :

Continue to treat dilapidations payments as further consideration for the supply under the lease; or

Revert to treating them as outside the scope of VAT, if that had been their practice prior to the 2020 brief.

This interim approach allowed some breathing space, but uncertainty remained until HMRC could provide more definitive advice.

Draft Revised Guidance - August 2021

In August 2021, HMRC circulated a draft of its revised guidance for consultation. In this draft, HMRC acknowledged the concerns raised and set out its updated view :

"Our policy, having weighed these factors, is not to treat dilapidations payments as further consideration for the supply of a lease. We might depart from that view if in individual cases we found evidence of value shifting from rent to dilapidations payment to avoid accounting for VAT."

This was a welcome and reassuring clarification. In essence, HMRC confirmed that, generally speaking, dilapidations payments should not be treated as consideration for a taxable supply and are therefore outside the scope of VAT.

However, HMRC did leave open the possibility of challenge. For example, in cases where parties manipulate figures to shift value from rent (subject to VAT) into dilapidations payments (not subject to VAT) as a tax avoidance tactic.

VAT Notice 742 and Land and Property Transactions

This updated position is consistent with HMRC’s broader guidance in VAT Notice 742: Land and property, revised in December 2020. Section 10.12 of the notice states :

"A dilapidation 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."

Thus, under normal commercial circumstances, landlords and tenants can rely on the principle that dilapidations payments are not subject to VAT.

VAT and Dilapidations : Practical Implications for Landlords and Tenants

The clarification on VAT and dilapidations brings much-needed certainty to lease-end negotiations. However, there are several practical considerations to keep in mind :

Lease Terms - Landlords and tenants should review lease terms carefully to understand VAT obligations under the lease, particularly where an option to tax has been exercised.

Settlement Agreements - Care should be taken when drafting and settling dilapidations claims. Ensure that the nature of payments is clearly identified to avoid later disputes over VAT treatment.

Record Keeping - Retain thorough records of lease obligations, dilapidations schedules, and settlement discussions. This will help defend the VAT treatment adopted if HMRC reviews the transaction.

Avoid Value Shifting - Be cautious about structuring settlements to artificially shift value from rent to dilapidations. Such arrangements could invite challenge from HMRC.

Professional Advice - Always seek professional advice from tax specialists and property consultants to ensure compliance with VAT rules when dealing with significant dilapidations claims.

Conclusion: VAT and Dilapidations — A Settled Position?

Following the release of HMRC’s revised guidance, most landlords and tenants can now be confident that dilapidations payments are generally outside the scope of VAT. This restores a degree of stability and predictability to commercial lease negotiations and exits.

However, the warning about value shifting should not be ignored. Parties must continue to approach dilapidations settlements with transparency and integrity.

For anyone involved in commercial property — whether as a landlord, tenant, surveyor, solicitor, or tax advisor — understanding the VAT implications of dilapidations is essential. As always, staying informed and seeking expert advice can help prevent costly errors and ensure smooth lease transitions.

For further advice on VAT and dilapidations, or for assistance with managing your dilapidations liabilities, contact our specialist team today.

Resources

For more information on this topic, check out our blog on Dilapidations and tax relief.

See our Dilapidations Fact Sheet for more information.

Dilapidations Blog for further information on a range of Dilapidation topics.

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