What are the VAT implications of lease variations?

It has become more common in recent years for landlords and/ or their tenants to want to change the terms of their commercial lease. This situation can arise where a tenant is experiencing financial difficulties and the landlord agrees to vary the lease to help with cashflow, or a landlord wants to secure ongoing letting of its property.

Whatever the reason for the lease renegotiation, there are potential VAT implications to making these changes. We discuss below some common scenarios and the consequences that may apply.

Scenario 1: Varying the lease to reduce the rent

A lease has been renegotiated to reduce the tenant’s rent payments. So, what’s next?

The first question to consider is whether the tenant has agreed to do something in return for the rent reduction. There’s no such thing as a free lunch. Or is there? If the tenant has agreed to do something in return, then HMRC deems this to be the tenant giving consideration for a supply made to them by the landlord.

1. Is there a supply for VAT purposes?

A. No consideration has been given by the tenant for the variation

Where a tenant pays no more than a peppercorn fee or provides no other form of consideration to the landlord in order to benefit from a reduced rent, then the tenant is not making a supply to the landlord. There are likely to be no changes to the supplies the landlord is making to the tenant either. This also applies to:

• reduced rent;
• rent-free periods; and
• rent holidays.

Consequence

The tenant is not required to issue any VAT invoices or submit any returns to HMRC in relation to this rent reduction. They can sit back and enjoy the rent reduction. 

Where the landlord has opted to tax the property, they should simply account for the VAT on the revised rent and submit the appropriate VAT returns to HMRC.

B. The tenant has agreed to do something in return for the variation

Where a tenant agrees to do something in return for the reduced rent, for example undertake works on the property, then this could be classed as a supply by the tenant to the landlord. Be aware that often HMRC sets the bar very low as to when the tenant “has agreed to do something”.

Consequence

Where the landlord has opted to tax the property, they will have to account for the VAT as though the full rent was still being paid. HMRC’s interpretation is that although the monetary rent has been reduced, the rent is being satisfied in kind (i.e. by the tenant agreeing to “do something” in return). VAT returns should be submitted to HMRC accordingly.

When the tenant has agreed to do something, this constitutes a supply for VAT purposes by the tenant to the landlord; the reduction of rent will be the value of the supply. Whether this supply by the tenant is taxable or exempt will depend on the type of supply. For example, where the tenant has undertaken works on the property in return for a reduced rent, these works will be a standard rated supply. Under HMRC’s analysis, the tenant will be carrying out these works for a valuable consideration i.e. the rent reduction.

Where the tenant is VAT registered, they will have to issue a VAT invoice to the landlord for an amount equal to the rent reduction. The tenant may also be able to recover any input VAT incurred if they are making a taxable supply, but only in relation to the VAT incurred on that supply.

Scenario 2: Change in break clause or extending the lease

A lease has been renegotiated to remove the tenant’s right to break the lease. So what’s next? Again, the first thing to consider is whether anything has been given in return.

1. Is there a supply for VAT purposes?

A. No consideration is given by the tenant for the variation

If the tenant has not provided anything in return for this variation, then the simple agreement to amend the break clause in the lease is not classed as a supply. Equally, no supply is made where a tenant simply agrees to pay rent under an extended lease.

Consequence

For the tenant, it is unlikely that there will be additional VAT implications to worry about.

For the landlord, where they have opted to tax, they should simply account for the VAT on the rent that is due in line with the revised terms and submit the appropriate VAT returns to HMRC.

B. Consideration in the form of money has been given by the landlord in return for the variation

Where the tenant agrees to the removal of a break clause or an extension of a lease in return for monetary consideration, then this may be a supply by the tenant to the landlord. As a general rule of thumb, HMRC are of the view that if a person is paid a monetary amount this is consideration for a supply made by that person; in other words, the person must do something as a justification for the payment of the monetary amount to it.

Consequence

Where the tenant makes a supply, the value of the supply will equal the money paid in exchange.

If the tenant has opted to tax, they will be making a taxable supply and will have to account to HMRC for the VAT and issue a VAT invoice to the landlord. The tenant may be able to recover any input VAT relating to that supply. If the tenant has not opted to tax they will be making an exempt supply and so no VAT is chargeable.

Where the landlord has opted to tax the property, they will have to continue to account for the VAT on the rent and submit the relevant VAT returns to HMRC.

2. But does the break clause variation give rise to anything more?

HMRC clarified in 2020 that the waiver of a break clause in return for consideration that’s not wholly in money, for example, a rent-free period, will not be treated as a supply by the tenant because it has the effect of ensuring rent is paid for a longer period.

However, there still remains scope for a potential ‘barter transaction’ to arise where something more than paying rent for a longer period is agreed. A barter transaction is where there are two separate non-monetary supplies made by the landlord and the tenant respectively. The VAT consequences are complex and will need a detailed consideration on a case-by-case basis.

Scenario 3: Surrender and regrant

1. Actual surrender and regrant

The landlord and tenant agree to the surrender of an existing lease and the regrant a new lease. So what’s next?

If there is an actual surrender and regrant, as opposed to a deemed surrender and regrant (see below at point 2), then there may be a barter transaction if the surrender is consideration for the grant of the new lease (or vice versa). Equally, if there’s cash consideration given for the surrender and regrant, any non-monetary consideration will form part of the total consideration.

Consequence

The VAT liability of each supply depends on whether the landlord and tenant have opted to tax. If the landlord and tenant have both opted to tax, then VAT invoices may be issued to each other. VAT will be charged on the money’s worth value of the supply.

If the tenant has not opted to tax, the supply will be exempt and exempt supplies cannot be included on any VAT invoice. If the tenant is VAT registered, it will still need to reflect the consequences of the exempt supply in their VAT return.

Where a landlord has opted to tax, then VAT invoices will need to be issued to the tenant and the appropriate VAT returns will need to be made to HMRC. No VAT invoices need to be issued by the landlord if they have not opted to tax and no VAT returns need to be submitted to HMRC if they are not VAT registered.

2. Deemed surrender and regrant

A lease has been renegotiated to change the term. So what’s next?

Where an existing lease is varied to change the term or the demise (in other words the premises transferred under the lease), then this is deemed to be a surrender of the existing lease and a grant of a new one. Whether there are VAT implications again depends on whether there is a supply.

There’s no such thing as two free lunches. Or is there?

2.1 Is there a supply?

A. No consideration is given by the tenant for the variation

A deemed surrender and regrant is treated the same as a variation of a lease. Where no money is given as consideration for a variation of the lease, no supply has taken place and HMRC appears not to consider the surrender of a lease to be consideration for the re-grant.

Consequence

The tenant is not required to issue any VAT invoices or submit any returns to HMRC.

Where the landlord has opted to tax, they should simply account for the VAT on the rent that is due in line with the variation.

B. The tenant has agreed to do something in return

If either the landlord or the tenant receives any monetary consideration for the surrender and re-grant, then this may have VAT implications. HMRC normally sees payment by the tenant to be consideration for the grant of the new lease.

Consequence

Where the tenant surrenders a lease to the landlord in return for a payment from the landlord, then the tenant is making a supply, which is exempt from VAT unless the tenant has opted to tax.

Where a tenant has opted to tax, then a VAT invoice will need to be issued to the landlord and this will need to be accounted for in the VAT return made to HMRC. No VAT invoices need to be issued by the tenant if they have not opted to tax and no VAT returns need to be submitted to HMRC if they are not VAT registered.

Where the tenant surrenders a lease and pays consideration to the landlord, the landlord is treated as gaining an interest in land by accepting the surrender. This surrender is exempt from VAT unless the landlord has opted to tax.

Where a landlord has opted to tax, then VAT invoices will need to be issued to the tenant and the VAT will need to be accounted for via the landlord’s VAT return. No VAT invoices need to be issued by the landlord if they have not opted to tax and no VAT returns need to be submitted to HMRC if they are not VAT registered.

2.2 Other VAT considerations

In February 2022, HMRC confirmed that with effect from 1 April 2022, any payments made for early termination pursuant to a break clause will be treated as consideration for a supply. Previously the consideration had been thought to be outside the scope of VAT. For example, where a tenant pays an agreed fee under a break clause to the landlord to exit the lease, this will be treated as consideration for a supply made by the landlord (i.e. the accepting of the lease surrender). The VAT treatment will depend on whether the landlord has exercised the option to tax.