Unfortunately, the current economic climate means that more tenants are taking the difficult decision to approach their landlord to discuss ending their commercial property lease.
A surrender means that a lease is terminated before the end of the contractual term. This can be done either:
- informally (known as a “surrender by operation of law”) – this is where, for example, the tenant hands the keys back to the landlord, removes its items and walks away from the property; or
- formally – this is when the surrender is documented in writing, usually in a deed (known as a “deed of surrender”).
Before a lease is officially terminated, the parties will need to negotiate – as a general point, unlike exercising a break clause, landlords are not (in most circumstances) contractually obliged to agree a surrender with a tenant, and so a landlord is likely to expect to be compensated financially. Areas the parties need to look at include:
- compensation for future loss of rent – will a premium need to be paid?
- outstanding obligations in relation to repair of the property – does the landlord need to be compensated for items of disrepair that are the tenant’s responsibility?
- legal costs - it is generally commercially accepted that the tenant should pay for not just their own costs, but also those of the landlord.
So what about VAT, and how does it apply here? In simple terms, if a landlord accepts a payment in return for surrendering a lease, then this is the tax point for VAT purposes. This means that a surrender will be VAT exempt unless the landlord has opted to tax the land, in which case the payment will be subject to VAT.
An exception to this is where the payment relates solely to dilapidations. In this situation, guidance from HMRC suggests that such payments are not treated as further consideration, and instead are “normally” outside the scope of VAT. Therefore, any payment made to the landlord in settlement of a tenant’s repair obligations would not attract VAT, even if the landlord had made a VAT election in relation to the property.
For cash strapped tenants, it might on the face of it seem an attractive option to treat any payment to the landlord as solely relating to dilapidations to avoid VAT, but a tenant should exercise caution:
- HMRC are alive to the possibility of “value shifting” from a payment relating to compensation for loss of rent, to a payment being solely in compensation for any dilapidations to avoid accounting for VAT;
- Penalties and interest can be added by HMRC to any late or outstanding VAT bill, which can be significant; and
- HMRC have explicitly stated that if there is any suspicion that VAT has not been paid when it was due, they have the ability to look back at transactions which have completed up to four years ago, which is potentially a worry for tenants who thought that they had already brought any obligations associated with their previous lease to an end.
In summary, the position on VAT when surrendering a commercial lease is not clear cut, and this is where Higgs are here to help. We can work alongside your specialist tax advisers such as your accountants, so that you can avoid an unexpected VAT bill later down the line.
