HMRC change their practice on VAT treatment of lease variations. Revenue & Customs Brief, RCB represents a change in the way HMRC treats lease variations for VAT purposes when the landlord reduces the rent and the tenant agrees to waive or change their termination right. Although the HMRC says there has been no policy change, many homeowners will be happy to see that the RCB allows for a smarter approach. The RCB is issued in response to the frequency of lease variations due to the impact COVID-19 has on the commercial real estate industry, especially for commercial tenants.
The issue with the old HMRC practice
COVID-19 has resulted in a slew of lease variations with landlords seeking to secure the continued rental of their real estate. Tenants most of the time ask for a reduction in rent or a rent-free period, in exchange for agreeing to continue renting the property from the owner. These agreements entail modification of the existing lease, to reflect the reduction or suspension of the rent and the removal of a right of termination of the future tenant (so that the tenant cannot terminate the lease).
HMRC has previously taken the approach that anything given in exchange for a reduction in rent or a rent-free period can be considered consideration for VAT purposes, including the tenant's agreement not to exercise his right of termination.
The lessor was then considered by HMRC to be making a supply to the lessee in return for the removal of the suspension of rent option, and the lessee was also considered to be making a supply to the owner in return for the reduction in his rent. The value of the two supplies would correspond to the rent reduction. In practice, a landlord who chose to tax a property was required to charge VAT to the tenant. The tenant would also be required to charge VAT if they had chosen to tax, although in practice this is less common. HMRC expected VAT to be charged based on the amount of rent given up by the landlord, based on the assumption that landlord and tenant were providing each other with something of equal value (and indeed, this approach is always reflected in VAT Notice 742., paragraph 10.2).
In practice, this has often created problems, especially among tenants who have found themselves unable to recover the VAT charged by the landlord. Further confusion has arisen from other indications of VAT on rental variations: intended primarily to clarify the treatment when a modification triggers a deemed discount and reassignment, they pointedly suggest that a lease modification which extends the duration of the rental agreement can never give rise to VAT, unless a monetary consideration has been involved.
Valuation issues also contributed to complicating the situation. According to VAT law, it is the lessor who must invoice VAT on the basis of the subjective value on which the parties have agreed as consideration for the delivery. It is not always correct that the value will be the same as that of the rent assigned by the owner. A landlord who has had to reduce rent in order to keep a financially troubled tenant afloat may waive the tenant's break-up right in the hope that they will stay afloat will likely not consider removing the break-up right to have the effect. same value as the abandoned rent amount on paper.
The change in HMRC practice
The HMRC no longer considers the mere fact of waiving a right of termination (or agreeing to extend the term of the lease) as consideration for VAT purposes. No VAT will be charged to the tenant or the lessor (other than that on the rent), in the absence of a counterpart from the tenant.
There is a good legal basis for this position. In general, a commitment as a tenant to pay rent is not considered as consideration when a new lease is granted, and the same reasoning also appears applicable when the lessor grants a reduction in rent or free rental in order to ensure the continued rental of the property, whether this takes the form of acceptance by the tenant of a new lease or the removal of a right to terminate the existing lease.
Lease variations are notorious for creating VAT problems. Thus, it is better to consider them on a case-by-case basis. However, the RCB reports that HMRC does not expect landlords or tenants to charge VAT when the tenant waives a right to a break only in exchange for a reduction in rent or a free period. To set up this type of agreement, do not hesitate to consult a lawyer in real estate law.