HMRC has today published Revenue & Customs Brief 11 of 2020 (RCB), concerning the VAT treatment of lease variations. The RCB represents a change in the way HMRC have treated lease variations for VAT purposes where the landlord reduces the rent and the tenant agrees to give up or vary their break right. Although HMRC assert that there has been no change in policy, many landlords will be pleased to see that the RCB heralds a more sensible approach. The RCB is being issued in response to the frequency of lease variations as result of the impact of COVID-19 on the commercial property sector, particularly for retail tenants.
COVID-19 has resulted in a large number of lease variations where landlords seek to secure the on-going letting of their property investments. Tenants will often insist on a reduction in rent or rent-free period, in return for agreeing to continue renting the property. These deals commonly take the form of a variation to the existing lease, reducing or suspending the rent, and removing an upcoming tenant break right (which would otherwise have allowed the tenant to terminate the lease).
HMRC has on previous occasions taken the approach that anything done in return for a reduction in rent or a rent-free period can count as consideration for VAT purposes, including a tenant’s agreement not to exercise a break right. The landlord was seen by HMRC as making a supply to the tenant in consideration for the tenant removing its break option, and the tenant was likewise seen as making a supply to the landlord in consideration for the reduction in the rent. The value of both supplies would usually be equal to the rent reduction. The result in practice was that a landlord who had opted to tax a property was required to charge VAT to the tenant. The tenant would likewise be required to charge VAT if it had opted to tax, though in practice this is less common. HMRC expected VAT to be charged by reference to the amount of rent given-up by the landlord, based on an assumption that the landlord and tenant were providing something of equal value to each other (and indeed this approach is still reflected in VAT Notice 742, paragraph 10.2).
This often created problems in practice, especially among tenants unable to recover the VAT charged by the landlord. Additional confusion arose from other VAT guidance on lease variations: apparently intended to clarify the treatment where a variation triggers a deemed surrender and re-grant, it ostensibly suggests that a lease variation which extends the term of the lease can never give rise to VAT unless monetary consideration was involved.
Valuation issues have also complicated the position. VAT law requires the landlord to charge VAT based on the subjective value that the parties can be regarded as having treated as the consideration for the supply. It is not always the case that the value will be the same as the value of rent given up by the landlord. Take the example of a landlord forced to reduce the rent to keep afloat a tenant in financial difficulties, where the tenant’s break right is removed as little more than a gesture, in the hope that it survives. In that situation the landlord is unlikely to consider that removal of the break right was worth the same as the amount of rent given up on paper.
The change in HMRC practice
The RCB contains an example which demonstrates that HMRC will be following the approach that merely giving up a break right (or agreeing to extend the term of the lease) will not be seen as consideration for VAT purposes. No VAT would be chargeable by the tenant or the landlord (other than in respect of the rent), absent anything additional being given or done on the tenant’s part.
There are good legal grounds for that position. Broadly speaking, promising to be a tenant and to pay rent is not treated as consideration when a new lease is granted, and the same reasoning (set out in the Mirror Group case (C-409/98) appears equally applicable where those promises are made during the course of an existing lease. In both situations the landlord is giving a rental reduction or rent-free in order to secure the on-going letting of the property, regardless of whether that takes the form of the tenant accepting a new lease or removing a break right from an existing lease.
Lease variations are notorious for the VAT issues they create, and are best considered on a case-by-case basis. However, the RCB signals that HMRC do not expect landlords or tenants to be charging VAT where the tenant does no more than giving up a break right, in return for a rent reduction or rent-free period.