In many cases this has been combined with a capital project to attract customers and/or staff back to their place of business. Special payments linked to the termination or inception of a lease have therefore been increasingly in the spotlight in terms of advising on the tax and VAT issues arising. This article looks at some of these types of payments in more detail, from both the landlord and tenant perspective.

Dilapidations

At the end of a lease, it is common for the tenant to pay a dilapidations payment to the landlord to restore the property to its former condition.

The basic rule is that dilapidations related to capital expenditure are not allowable as a deduction against profits, whereas payments which are essentially ‘deferred repairs’ are revenue in nature and therefore a deduction can be claimed.

To give a few examples, the demolition or re-building of a large part would be treated as capital, and therefore no deduction given. Whereas, replacing worn out cabinets and general decorating would be considered revenue.

One of the common queries we get is, “Am I able to provide for my expected dilapidations at the end of the lease, as the lease progresses?” Following accountancy principles, it may be possible to create a provision for dilapidations in certain circumstances, but whether they will be allowable for tax will turn on whether it is a general or specific provision. The former being disallowed.

Inducements: ‘Rent-free period’

Where a landlord wants to incentivise occupation of their empty building, it is fairly common to offer some sort of inducement to prospective tenants. These can take several different forms; either a rent-free period, cash, or a contribution to the tenant’s fit out costs.

The most common incentive we see is a rent-free period, or a reduction in rent for a fixed term. There are no special tax rules on such an agreement and so the accounting treatment determines the tax. Where a lease is offered at £100,000 per year for ten years, but with a first year rent-free period the actual cost of the ten-year lease is £900,000. The accounting treatment is to bring into account £90,000 per year. To illustrate this:

Adam offers Ben a ten-year lease at a rent of £100,000, with no payments until after the first year. Ben has to pay £900,000 on the lease over the ten years. He brings £90,000 into account each year and therefore gets a deduction from his profits of £90,000 for tax purposes.

Adam is taxed on £90,000 income per year.

Clearly this accounting treatment is advantageous to the tenant, who is able to claim a £90,000 deduction in year one despite having made no rental payment, and vice versa disadvantageous to the landlord from a tax cash flow perspective.

Inducements: ‘Reverse-premium’

The second most common incentive we see is a reverse-premium, which is a straight-forward cash payment made to a tenant for entering into a lease. Here, the landlord has made a capital payment and therefore receives no tax relief against the rental income. The tenant on the other hand would treat the premium as taxable income (normally as a trading receipt, or a receipt of a UK Property business). The accounting treatment is to spread the reverse-premium over the lifetime of the lease, so this ‘income’ gets taxed over the life of the lease. To illustrate this:

Ben, a landlord, offers a ten-year lease at a rent of £100,000 a year, with an upfront cash incentive payment of £100,000. Paul, the tenant who enters into the lease is treated as receiving £10,000 of taxable income a year. He receives a £100,000 deduction for his rental payments. The tax impact is identical to the scenario above for the tenant (i.e. a net £90,000 deduction from profits per year of the lease), but Ben has taxable income of £100,000 a year from rental payments as there is no clear mechanism for the landlord to claim deduction for the cash inducement payment.

Compared with the first option, this approach is potentially even more favourable for the tenant as not only do they get accelerated tax relief, but they also get an up-front cash flow benefit at the beginning of year one. However, this approach is normally less tax efficient for the landlord and therefore rent-free periods have become far more common in recent years that a physical reverse premium approach.

It’s worth mentioning that in both scenarios the tenant may have used the inducement benefit to help fund fit-out works to their new premises and a substantial proportion of those works will likely benefit from capital allowances such that there is even greater tax benefit to the tenant rather than the landlord.

Inducements: ‘Contributions to fit out’

An alternative option available to the landlord seeking a better tax outcome (than both of the above scenarios) whilst still offering an inducement is offering a contribution to fit out costs. As above, this capital contribution is normally treated as a reverse-premium and therefore a taxable revenue receipt to the tenant (in the same way as a cash payment is). However, it gets a little more complicated if the landlord has paid for the tenant’s capital costs, on which the tenant could claim capital allowances.

In this case, the tenant’s capital allowance claim is reduced to the net of their expenditure. Where the tenant would have been able to claim 100% first year allowances for the costs (either through the £1m Annual Investment Allowance or the new Full Expensing relief ), the tenant effectively suffers taxation on the whole inducement amount in the first year, which is worse than the basic cash reverse premium described above. To illustrate this:

Kate owns a retail premises which Mark wants to turn into a bicycle shop. Mark knows he will need to incur about £150,000 of fit-out costs to prepare the shop (all of which would qualify for capital allowances). Kate offers to pay for £100,000 of those costs to get Mark to enter into the lease. The ten-year lease is for a rent of £100,000 per year.

Mark can receive a deduction for rent paid of £100,000 per year. The contribution is not treated as a taxable receipt, because it is for items that qualify for capital allowances. Instead, Mark’s capital allowance claim is for £50,000 (the £150,000 spent on capital items, less the £100,000 contribution). None of the £100,000 is taxable as income but is has reduced the capital allowance claim.

Kate is taxed on £100,000 income per year and has spent £100,000 upfront, but she can potentially then claim capital allowances (herself) on the contribution made towards the plant and equipment. Therefore, this third approach may be more favourable to the landlord, purely from a tax point of view, however it is also likely to be the most complex (for example, who approves the contractor and agrees their bills?). In what is ostensibly a tenants’ market (with lots of empty commercial space in certain sectors), situations where a landlord can insist this third route is taken will in our view become even less common.

The main consideration to any incentive offered should always be based on its commerciality and the objectives of the parties involved, but it is important to make sure that the tax effect is understood so that there are no nasty surprises. Given the complexity of this area, it is always best to seek proper advice.

What are the VAT implications?

With the above in mind, it is clear that the direct tax consequences can be complex, so it is also worth considering the VAT implications of these same issues.

Many landlords in the current climate would dearly love a situation where soon after one lease ends a new one is granted. There are, however, a number of VAT issues to understand when either situation applies. The issues highlighted below make the assumption that the landlord is making a taxable supply of a commercial property – i.e. that there is a valid option to tax in effect. There are potential issues when the landlord and tenant are associated which could disapply the landlord’s option to tax, but that article is for another day.

When ending a lease early the tenant may have to make payment to the landlord to affect the termination (e.g. Break fees). As a payment to the landlord this is a supply by the landlord and as the assumption is that this is a taxable property this payment would usually be subject to VAT.

A payment by the landlord to the tenant to quit is a supply by the tenant so, unless the tenant has opted to tax, this supply is not subject to VAT.

When granting a lease, it’s fairly common for the landlord to offer a rent-free period to the new tenant. As there is no consideration, HMRC takes the view that there is no VAT declarable. However, if the inducement is more of a barter situation, then VAT is likely to be due. For example, a landlord offers a tenant a 6-month rent-free period but requires the tenant to finish off works that are (under a ‘normal’ tenancy) the obligation of the landlord - then there is VAT due on the value of the works – and HMRC is likely to start from the assumption that is the value of the rent foregone.

The difficulty is establishing where such an obligation would normally lie. The high-level view that the maintenance of the property is the responsibility of the tenant and the refurbishment, extension, upgrade, etc. is for the landlord is helpful but can lead to some significantly grey areas. Where the landlord hasn’t opted to tax the property, it’s not unheard of for the tenant to be asked to pay for costs that would be seen as proper to the landlord. Where the tenant has recovered the VAT on these costs it’s equally not unheard of for HMRC to assess the tenant for the VAT incorrectly claimed (as the recipient of the supply was the landlord) and add significant penalties to the assessment. Where a landlord has sought to regularise this position by having written into the lease that the tenant will provide such works with a view to making these supplies ‘normal’ for a tenant to undertake; HMRC has been known to successfully challenge this approach.

The incentive may be a payment from the Landlord to the tenant, often referred to as reverse premiums. Reverse premiums are usually outside the scope of VAT, if the tenant does no more than accept the terms of the lease, but if the tenant is seen as offering more than that then the VAT treatment does change.

One such area is that of an ‘anchor tenant’ (i.e. a tenant with a reputation or name that is likely to encourage other prospective tenants to take a lease in the same development). If a business agrees to act as an anchor tenant this will usually involve them being actively promoted as such in marketing campaigns for the property. HMRC may see such co-operation as a supply. Another potential problem is that as an anchor tenant it is likely to get greater incentives to take up the lease than other prospective tenants. In these circumstances you should take advice to see ensure that unforeseen VAT traps are not created as a result.

When a tenant leaves it’s often a requirement on their part to pay dilapidations (dilaps). In September 2020 HMRC issued some infamous guidance about how their view that previously non-taxable compensatory payments (but not explicitly dilaps) were now subject to VAT. The infamy was that the guidance said business had to calculate and notify HMRC of the VAT under-declared in the last four years due to their ‘error’ of following HMRC’s now incorrect view. The backdating element of this sea-change in VAT treatment was soon withdrawn; but not HMRC’s new views of the VAT treatment. A rumour persisted that HMRC was considering how such VAT changes may apply to dilaps. Since then, HMRC has confirmed they are not planning to make dilaps subject to VAT (although they did weigh up the issue) and they remain outside the scope of VAT, unless HMRC perceives that there is value shifting to reduce the amount of VAT due.

If you would like to discuss your specific circumstances, please get in touch.

Disclaimer: The information provided in this article is intended for general informational purposes only and does not constitute tax, accounting or legal advice.