Recent changes in HMRC policy towards the VAT treatment of termination payments and forfeited deposits have the potential to impact real estate transactions, potentially creating additional costs for taxpayers.
Termination fees and compensation payments
On 2 September 2020, HMRC published Revenue & Customs Brief 12 (2020) entitled “VAT early termination fees and compensation payments” (the 2020 Brief).
The 2020 Brief describes a change in HMRC policy; whereas previously HMRC guidance stated that when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply (being compensatory in nature) and therefore were outside the scope of VAT, its policy now is that these charges are normally considered as being for the supply of goods or services which were the subject matter of the customer’s contract. Therefore, HMRC’s view now is that most early termination and cancellation fees are therefore liable for VAT, even if they are described as compensation or damages.
The 2020 Brief does not go into any great detail, but it would appear from corresponding updates to HMRC’s internal guidance that this change in policy could impact the VAT treatment of break options contained within leases. Where a tenant is paying a break fee to exercise its option to terminate a commercial lease, HMRC policy would now appear to be that the payment of the break fee will be subject to VAT where the landlord has opted to tax the property. Previously, it was understood that the payment of a break fee would be outside the scope of VAT provided that the requirement to pay the break fee was included in the original terms of the lease at the time of grant.
It will therefore be important for landlords to recognise situations where they should be charging VAT in addition to break fees (as this is a departure from past practice). Tenant’s will also wish to understand whether they should or should not be paying VAT in addition to the break fee, particularly where the tenant is unable to recover some or all of that VAT.
This change also appears to impact situations where a party is seeking to withdraw from a contract to acquire property. For instance, taxpayers have often taken the view that where a seller and buyer have exchanged a contract for the sale and purchase of land, if the buyer subsequently makes a payment to be released from the contract (distinct from the situation where a deposit is forfeited – see below) that payment is outside the scope of VAT as compensation. It appears that HMRC now considers that the VAT treatment follows the subject matter of the underlying contract, so that if the seller was going to charge VAT on the sale of the property then it must also charge VAT on the payment for the release of the contract.
Perhaps even more significantly, HMRC’s internal guidance indicates that a payment of “liquidated damages” made on termination of a contract should no longer be considered compensation but instead be treated as a payment for the subject matter of the contract. This could have a significant impact on the construction sector where contracts regularly contain liquidated damages provisions, although it is not clear at this stage whether the change in HMRC policy extends only to situations where liquidated damages are paid on termination of a contract or whether it has wider application.
Forfeited deposits and other “unfulfilled supplies”
This change in policy follows on from a similar change set out in Revenue and Customs Brief 13 (2018) entitled “change to the VAT treatment of retained payments and deposits” (the 2018 Brief).
As with the 2020 Brief, the 2018 Brief explains that HMRC’s changes of policy arise from a number of cases decided before the Court of Justice of the European Union.
Prior to the publication of the 2018 Brief, HMRC generally accepted that payments for “unfulfilled supplies” (i.e. where the supplier retains a deposit or pre-payment made by the customer in circumstances where the supplier does not actually proceed to supply any goods or services to the customer) were “compensation” and therefore fell outside the scope of VAT.
HMRC’s policy now is that when a full or part payment is made on account for a taxable supply, VAT becomes due on the amount paid even where the supplier does not actually proceed to make an actual supply of goods or services. HMRC’s view is that the payment, when made, is consideration for a supply that is expected to be taxable and the nature of the payment is not altered if, at a later date, the supply of goods or services is not actually made.
In the real estate sector, a common example of an unfulfilled supply would be where a buyer pays a deposit to the seller on exchange of a contract to buy property and, due to the buyer failing to complete the purchase, the deposit is forfeited to the seller.
As per the above, forfeited deposits have commonly been seen as compensation to the seller for the sale falling through and therefore outside the scope of VAT. However, in discussions with industry subsequent to the publication of the 2018 Brief, HMRC has specifically confirmed that where a deposit is paid in respect of a property where the seller is expecting to charge VAT in addition to the purchase price, then VAT is due on the deposit if that deposit is forfeited to the seller.
This change in policy should not have any practical impact on situations where the sale of the property is intended to be VAT exempt or zero-rated (as will typically be the case on the sale of residential property), as the forfeited deposit will be treated as consideration for an exempt or zero-rated supply (and no VAT will arise as a consequence).
However, we are seeing that this has practical implications where the sale of the property is expected to be subject to the standard-rate of VAT (such as where the seller has opted to tax the property or where the seller is selling a freehold interest in a new commercial building).
In these circumstances, where the deposit is paid to the seller “as stakeholder” (as is commonly the case), there is no immediate obligation on the Seller to account for VAT in respect of the payment of the deposit.
However, if the deposit is later forfeited to the seller, the seller will become liable to account to HMRC for VAT in relation to the deposit (this is in contrast to the previous approach whereby the forfeited deposit was treated as compensation and outside the scope of VAT).
Therefore, the seller might argue, the buyer should be required to pay to the seller an amount equal to the agreed deposit plus an amount equal to the VAT (in order to ensure that it will be in funds to account for VAT to HMRC in the event that the buyer later defaults and the deposit is forfeited to the seller).
The buyer may be unwilling to accept this approach, arguing that as the seller will hold the deposit as stakeholder, the buyer will not be provided with a VAT invoice and therefore will be unable to recover the VAT (at least until either the property sale completes or the deposit is forfeited – if the deposit is material and there is a significant gap between exchange and completion this could be a considerable timing cost to the buyer).
The seller might then counter that it does not wish to have to separately pursue the buyer for the payment of VAT in the event that the deposit has been forfeited (presumably in circumstances where the buyer has defaulted).
This is ultimately a matter for commercial negotiation, although there may a possible compromise whereby the seller issues a VAT invoice and part of the deposit is released absolutely to the seller to enable it to account for VAT to HMRC (although the full legal and tax implications of this approach should be considered).
The position is less controversial where the deposit is held as “agent”, as the seller is liable to account for VAT on receipt of the deposit and can therefore issue the buyer a VAT invoice (as has always been the case). The seller should therefore ensure that it receives in cash from the buyer an amount equal to the agreed deposit plus VAT. If the deposit is then forfeited to the seller, no further action is required for VAT purposes (in contrast to the previous approach where a refund of VAT may have been sought).If you would like to discuss any issues arising from this article, please contact Daniel Kennedy or your usual Shoosmiths contact.