VAT and break fees

The Inner House of the Court of Session has held that a tenant was required to pay VAT in addition to a break fee when exercising its option under a break clause in February 2021: Ventgrove Ltd v Kuehne + Nagel Ltd [2022] CSIH 40. The Court has overturned the decision of the lower court, holding that the correct VAT position had been clear and there was no legitimate expectation arising from HMRC guidance to the contrary.

The decision on the VAT treatment of break fees aligns with HMRC’s most recent guidance in Revenue & Customs Brief 2 (2022). The decision is also relevant to the ability of taxpayers’ ability to rely on HMRC guidance in circumstances where it is superseded by later court decisions.

Background

Ventgrove was the landlord of premises on an industrial estate in Scotland occupied by Kuehne + Nagel (KN) under the terms of a lease providing for rental payments of £450,000 per annum. Ventgrove had opted to tax the property. The lease contained a break clause entitling KN to terminate the lease from December 2021 by payment of the sum of £112,500 plus VAT if any, provided notice was given by March 2021.

In February 2021, KN gave notice to exercise the break clause and paid the sum of £112,500 to Ventgrove. Ventgrove, however, contended that KN had failed to validly exercise the break clause as it had failed to pay VAT in addition to the £112,500. In the case that came before the Scottish courts, the issue was whether the lease was validly terminated, which turned on the question of whether any VAT was properly due on the £112,500.

KN relied on the decision of the VAT Tribunal in Lloyds Bank plc v Commissioners of Customs and Excise (LON 95/2424) where HMRC’s policy was recorded as follows: “the Commissioners agree that if the option for determination or right of early determination...had been included in the original leases, the Commissioners would have followed their policy not to treat this as a taxable transaction……The Tribunal accepts... that it is the Commissioners present policy not to treat the exercise of an option to terminate within an original lease as a taxable transaction, although, as that policy is based neither on a provision of law or on decided authority, it does not bind the Tribunal.”

Ventgrove pointed, however, to the publication by HMRC of Revenue & Customs Brief 12/20 in September 2020, which recorded that HMRC had changed their policy on compensatory payment made under the terms of the original contract as a result of ECJ decisions in Vodafone Portugal (C-43/19) and MEO (Case C-295/17) and set out the new policy in VATSC05920.

The policy changed from that set out in the Lloyds case to the following: “HMRC’s policy is to treat payments arising out of early contract termination as consideration for a taxable supply. Businesses must account for VAT on these fees. This applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached.”

However, on 25 January 2021 HMRC altered its position and updated the Brief to make it clear that the change in policy was not to be given effect until a later date: “After communication from businesses and their representatives, HMRC has decided to apply the updated VAT treatment set out in this brief from a future date. We will issue revised guidance, and a new Revenue and Customs brief to explain what businesses need to do shortly.”

The Scottish Court of Session held that the cases of Vodafone Portugal and MEO could be distinguished from the present one and the tenant was entitled to rely on HMRC guidance that no VAT was payable on a break fee included as part of the lease since the revised guidance (to the opposite effect) had been suspended.

Decision of the Court

The Inner House of the Court of Session has reversed that decision, holding that VAT was due on the break fee payment and there was no basis for reliance on HMRC guidance to the contrary.

Firstly, the Court held that the decision in Lubbock Fine v HMRC [1994] QB 571 concerning VAT on reverse surrenders was equally applicable to break fees included in a lease. The exercise of the break option was a reverse surrender which would be treated by HMRC as a standard-rated supply where, as here, the landlord had opted to tax the property.

This point was reinforced by the recent CJEU decision in MEO and Vodafone Portugal, which the Court held were directly on point. The lower court had distinguished MEO and Vodafone Portugal on the ground that in the present case the tenant did not fail to comply with a minimum tie-in period but exercised a right to bring the lease to an end. The Court rejected the argument that this was a material distinction. “In each case the economic reality is that one party to a contract is exercising a contractual right to bring the contract to an end, by making a payment to the other party that would not have been payable if the contract had continued to run to a termination date envisaged in the original contract.”

Accordingly, the correct application of VAT law led to the conclusion that VAT was due on the break fee.

Secondly, the Court rejected the argument that there was a legitimate expectation that transaction would be taxed based on HMRC’s statements in the Lloyds Bank case. For the landlord to have relied on legitimate expectation, it would be necessary to show that the claim for VAT in such circumstances would be so unfair as to amount to an abuse of power.

The Court held that the passages in Lloyds Bank would not have amounted to a sound basis for any legitimate expectation that no VAT would be charged on the break option payment. In the first place, the policy was not published by HMRC as guidance; it was simply reported in observations which did not affect the outcome of the Lloyds Bank case itself. Secondly, it was expressly acknowledged in that case by the Commissioners, through counsel, that the policy was “not necessarily correct”. Thirdly, the Court observed there was no mention of such a policy in HMRC guidance.

(Somewhat strangely, as something of an afterthought, the Court did admit that HMRC had later drawn the Court’s attention to a paragraph (VATSC06720) in its Manuals referring to Lloyds Bank and stating that there was no supply for VAT purposes where a contract originally contained a clause allowing the parties to terminate early in lieu of compensation for perceived losses arising from the termination. The Court however rejected the suggestion that this was relevant to its judgment. In particular, VATSC06720 was one of the paragraphs of guidance withdrawn by Revenue & Customs Brief 12/2020 and had not been directly relied on by the tenant in its arguments.)

In any event, the Court held that once the erroneous foundation of the policy described in Lloyds Bank had been made clear by the decisions in MEO and Vodafone Portugal, it would not no longer be so unfair as to amount to an abuse of power for HMRC to depart from it in circumstances where it was shown by binding judicial authority to have been wrong.

Comment

HMRC has now finally issued determinative guidance on the VAT treatment of compensation payments which now applies the MEO and Vodafone Portugal approach to break fees. In addition, the case is of wider interest in showing what is necessary for a taxpayer to be able to rely on HMRC guidance. In particular, any guidance will, in principle, be superseded where the correct VAT treatment is shown to be contrary to HMRC’s approach in a later case.

However, one cannot held feel some sympathy for the tenant in this case. Despite what the Court has said, it was regarded generally as clear prior to the decision in MEO and Vodafone Portugal that HMRC guidance did treat the payment of a break fee contained in a lease as outside the scope of VAT. The dismissal of the relevance of VATSC06720 appears at least in part attributable to the fact that reference to it was only made after the hearings had finished.

Secondly, the decisions in MEO and Vodafone Portugal did create much debate around the scope of their application, leading to significant uncertainty at the time. The fact that HMRC issued guidance and then withdrew it and took over a year to reissue final guidance in Revenue & Customs Brief 2 (2022) is particularly strong evidence of this fact.

For information on the final guidance, see our article “HMRC revised guidance on contractual termination payments”.