by John Dick
Surrendering a lease might appear at first sight to be a relatively straightforward operation from the taxation standpoint. However, the recently introduced changes to the VAT legislation regarding land and buildings create a real pitfall for the unwary. These extensive changes were introduced by the Finance Act 1989 as a result of proceedings brought against the UK by the Community in the European Court. One of the less well publicised — but still very important — changes concerns the imposition of VAT in many cases where leases are surrendered.
Although the new legislation has been in force for more than a year, the VAT position still generates a fair degree of uncertainty in practice. This article therefore explores the VAT implications of a surrender and some resultant problems. It highlights one significant change in the official view in this area, and outlines a few possibilities which tenants may wish to explore in cases where a charge to VAT on a surrender is anticipated.
Prior to April 1 1989, the surrender of a lease by a tenant was treated as an exempt supply for VAT purposes. In no circumstances, therefore, could it give rise to a charge to VAT. This exemption has now been removed. The underlying reason for the change seems to have been that the EC 6th Directive — with which UK law must comply — does not specifically refer to the surrender of a lease as something which can properly be exempt. Rather than run the risk of a further reprimand from the European Court, the UK Government took the decision to remove the existing exemption altogether.
In consequence, the surrender of a lease is now a supply which is taxable at the standard rate where it is made for consideration and takes place in the course or furtherance of the lessee’s business.
Under the VAT division of supplies into those of goods and those of services, a surrender is treated as being a supply of goods if the lease has more than 21 years still to run. Otherwise it is a supply of services. The justification for distinguishing between the two cases is not at all obvious. Although the distinction can affect the time and place of supply for VAT, it is unlikely to be of material significance in most cases.
Some implications
The requirement that the surrender must be made in the course of furtherance of a business means that, in practice, many surrenders are completely outside the scope of the charge. For example, the surrender of a lease of residential accommodation will ordinarily be a domestic transaction quite unconnected with any business of the tenant. On the other hand, where a company or individual tenant surrenders for payment a lease of business premises, there is no reason why a standard rated supply should not be made. Likewise in the case of a farming tenant who is paid to surrender his agricultural tenancy.
This standard rating of a surrender applies irrespective of whether the business supplies normally made by the tenant are themselves standard rated, zero rated or exempt. But a tenant whose business supplies are normally exempt will need only to account for VAT on a surrender if the sum received takes him over the threshold for VAT registration.
The further requirement that consideration must be received for the surrender has the result that the business tenant who surrenders his lease in circumstances where he receives nothing at all for the surrender — because, for instance, the lease is at full rack rent and has no intrinsic worth — will not therefore suffer a charge to VAT.
Liability for tax and quantum of charge
It is not always appreciated that the responsibility for accounting for and paying VAT to Customs & Excise on a surrender lies squarely on the tenant himself, and not on the landlord. Also, unless the tenant has agreed with his landlord that the sum receivable for the surrender is to be exclusive of any VAT that arises, he will have to bear the VAT out of the sum received.
If, for instance, a tenant agrees to surrender his lease of business premises for £100,000, and nothing is said about VAT, he will be bound to account for the sum of £13,043 in VAT out of the £100,000 received. The payment to him will be regarded as a VAT inclusive sum. But this will leave him with £86,957 in hand at the end of the day, which could well be considerably less than he had envisaged. He will not be entitled to recover the VAT from the landlord.
The tenant can avoid this result only by stipulating for payment of a higher sum for the surrender, say £115,000, or by specifically agreeing with the landlord that the £100,000 to be paid for the surrender is to be exclusive of VAT. In both cases the landlord will be obliged to pay a total sum of £115,000, and the tenant will be bound to account to Customs & Excise for VAT of £15,000.
For his part, however, the landlord may well not accept that the ultimate burden of VAT should, in effect, be shifted on to his shoulders in this way. After all, he will be unable to recover the VAT as deductible input tax. The one exception to this is where he has opted to tax the rents received for the building or land concerned, since in that case he will be entitled to treat the VAT which he pays to the tenant on the surrender as a deductible input which can be set against his output tax.
Assignment in lieu of surrender
In the normal case where the landlord is unable to recover as an input the VAT paid by him on a surrender, it will therefore be worthwhile for the parties to try to arrange matters so that there is no surrender of the lease at all. For instance, if the landlord is a company, it may be feasible for the tenant instead to assign his lease to a subsidiary of the landlord. If necessary, the subsidiary could be newly created for this purpose. Such assignment will qualify as an exempt supply, and accordingly no VAT will be chargeable on the consideration received by the tenant.
At a later stage, the two interests held by the landlord and its subsidiary can be married. Provided proper care is taken, in the vast majority of cases no VAT will be exigible.
Using a VAT group
In other corporate cases it can often be possible to prevent a taxable surrender occurring by placing reliance on the legislative provisions relating to VAT groups in section 29 of the Value Added Tax Act 1983. This section enables a group of companies to apply for a single VAT registration for the whole group, and one consequence of being treated as a VAT group is that a supply by one member of this group to another is disregarded.
This is a highly technical area, but again careful structuring of the transaction should ensure that the original tenant is able to assign his lease to a member of the VAT group without giving rise to payment of VAT, even if ultimately the lease is absorbed into the landlord’s superior interest.
Change of view
Originally, Customs & Excise took the view that an assignment of a lease by the tenant to a company which is grouped with the landlord for VAT purposes should be treated as a VATable surrender. That view is set out in paragraph 12(c) of their notice entitled Property Ownership No 742B, published in January 1990. It was based essentially upon their interpretation of the legislation relating to VAT groups. However, following a query from the Law Society, the Customs recently changed their mind. They now accept that an assignment by the tenant to a VAT grouped company is not taxable provided the assignee is not the landlord. This recent change in the Customs’ interpretation is referred to in a press release of May 30 1990 issued by the Law Society.
Exchange of leases
So far the discussion has been limited to the case where the business tenant is paid in money for the surrender of his lease. But standard rating for VAT of a surrender applies equally where the consideration is in some other form. One area which seems to give rise to particular difficulty in practice concerns the exchange of one lease for another of the same premises, in other words a surrender and re-grant. Not infrequently, a tenant may decide to surrender a lease which has several years yet to run and under which he is currently paying a low rent. In return he may be granted a new and longer lease of the same premises at a higher rent, albeit one which is still at a level less than current market rents. The tenant ends up with a longer and more marketable lease and the landlord obtains an increased rent.
In 1989 it appeared initially that Customs did not propose to treat such a surrender as giving rise to a supply unless any money changed hands, for example the payment of a premium for the new lease. This was puzzling at the time, since it is difficult to think of any convincing argument in law why a taxable supply should not be made in these circumstances: the legislation specifically provides that VAT is chargeable where the consideration takes the form of money’s worth as well as where it is in money. But now it is reasonably clear that the official view is that a VAT charge does indeed arise in cases of surrender and re-grant, although there seem to be local variations in practice among VAT officers in applying it.
This charge can represent a serious problem for the unwary. First, and most seriously, the tenant finds himself having to pay VAT without having cash in hand from a surrender out of which to pay the tax. Second, he faces the possibility that Customs & Excise may not necessarily accept the value placed by him upon the new lease. Again, unless the landlord has opted to tax the rents received by him from the building or land in question, he is unlikely to be prepared to agree that VAT should be paid “on top” since it will not constitute a deductible input for him.
A “mezzanine” lease
The prospect of an unwelcome VAT charge on an exchange of leases points again to the desirability of landlord and tenant endeavouring to achieve their commercial objective without recourse to a surrender. One possibility here can be for the landlord to grant to a third party (“X”) a “mezzanine”, or overriding, lease for the term desired but subject to the existing lease of the tenant. In effect, the existing lease is thereby converted into a sublease with the new lease becoming the headlease. It will be inappropriate for X to be the tenant of what has now become the sublease since the result of that would be a surrender by operation of law — and, inevitably, a charge to VAT. On the other hand, there appears to be no fundamental objection to making X a trustee or nominee for the original tenant.
Conclusion
It will be apparent from the foregoing that a surrender, although it may be a relatively simple commercial transaction, can present considerable problems from a VAT standpoint. The consequences can be both unwelcome and a source of surprise to a tenant who is carrying on a business unless he is well aware of the position beforehand.
In many cases it will be possible, however, by structuring the transaction somewhat differently, to bring about a VAT-neutral situation in which either no surrender takes place or any surrender which does take place can be ignored for VAT purposes. The few examples outlined above serve to illustrate this, and also the broader point that the problems created by the recent imposition of VAT on many property transactions are by no means insurmountable.
