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A dilapidation payment is the money claimed by a landlord from a tenant upon the termination of a lease to cover the cost of repairs to a premises when a tenant has failed to return the premises to the landlord in the state and condition agreed in the lease.  Historically, HMRC treated dilapidation payments as representing claims for damages by landlords and, therefore such payments were considered to be outside the scope of VAT.  However, dilapidation payments were recently at the centre of a shift in consensus following two European Court cases.

In the wake of the two cases, HMRC released a Brief in September 2020 (RCB 12 (2020)), which indicated that certain payments (including dilapidation payments) that were previously considered compensation or liquidated damages payments and outside the scope of VAT, were actually considered to be consideration for the supply of goods or services and, therefore, subject to VAT.

However, following representations from industry, the Brief was suspended in January 2021 and, in February 2022, HMRC published RCB 2 (2022), which introduces a revised policy. The 2022 Brief confirms that, from 1 April 2022, dilapidation payments are not to be treated as further consideration for the supply of a lease and are, therefore, ‘normally’ outside the scope of VAT.  HMRC might depart from that view if, in individual cases, they find evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.

On the grant of a lease, the service being supplied is the grant of an interest in a premises.  In the 2022 Brief, HMRC addresses the question as to whether a dilapidation payment is sufficiently linked to the supply of the lease to be regarded as further consideration for it.  It was concluded that entering into a lease does not make a dilapidation payment inevitable.  A lease contains obligations on a tenant to keep a premises in a specific state of repair and condition.  If a tenant fails to comply with such obligations, this may give rise to a dilapidation payment on termination of the lease.  Therefore, the payment cannot be relied on as an additional form of consideration, as it may never materialise.

As mentioned, HMRC has confirmed that if there is evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT, HMRC may deviate from the view that the payment falls outside the scope of VAT.  Therefore, in order to avoid any question as to the legitimacy of a dilapidation payment, landlords should ensure that:

1. upon termination of the lease, the dilapidation payment is calculated separately to any other payments or surrender premiums;
2. dilapidation payments are clearly recorded in writing by a dilapidation settlement agreement.

This should help to demonstrate the clear break in the link between the payment and the supply of the lease.

For further protection, landlords entering into new leases could also include the right to recover VAT on dilapidation payments, should HMRC change its view on the VAT treatment of such payments in the future.