Inner House finds industrial estate tenant failed to validly exercise break option by not paying VAT on break sum

About this case:

• Citation:
  [2022] CSIH 40
• Judgment:
  External link
• Court:
  Court of Session Inner House
• Judge:
  Lord Tyre

Ventgrove Ltd sought to have defender Kuehne and Nagel Ltd’s exercise of the break option declared of no effect as it had failed to pay VAT properly due on the sum required to be paid. The tenant’s position was that VAT was not chargeable based on case law and the relevant HMRC guidance.

The appeal was heard by Lord Woolman, Lord Pentland, and Lord Tyre. Dean of Faculty, Roddy Dunlop QC, and Bremner, advocate, appeared for the appellant and Lord Keen of Elie QC for the respondent. An intervention in the case was made on behalf of HMRC, represented by R Anderson, advocate.

Reverse surrender

In December 2016 the parties entered into an agreement to lease premises at Kirkhill Industrial Estate in Dyce, Aberdeen. A break option was created allowing the tenant to terminate the lease after five years of the initial ten-year period, for which it required to give notice on or before a specified date and pay the sum of £112,500 “together with any VAT properly due thereon” to the landlord.

By notice dated 23 February 2021, the tenant exercised the break option and remitted the sum of £112,500 to the landlord. After the last date when the option could have been exercised, the landlord intimated that it refused to accept that the option had been validly exercised because the tenant had failed to pay the sum of £135,000, including VAT amounting to £22,500, said to be due on the payment of £112,500.

At first instance, the commercial judge took the view that HMRC’s policy, as recorded in Lloyd’s Bank plc v Customs and Excise Commissioners (1996), was that the exercise of an option to terminate that was included in the original lease was not within the scope of VAT. It was noted that HMRC had indicated a change in policy in September 2020 but had not yet given that change effect as of the time the payment was made.

On behalf of the landlord, it was submitted that the exercise of the break option was a reverse surrender which would be treated by HMRC as a standard-rated supply where the landlord had opted to tax the property. The indications in Lloyds Bank of a contrary policy that was “not necessarily correct” were not a sound basis for a conclusion that as a matter of law VAT was not chargeable on the break payment.

Counsel for HMRC acknowledged that any guidance issued was HMRC’s interpretation of the law and not the law itself and supported the position of the landlord. The tenant submitted that it was clear that the landlord would not have been assessed to VAT on the payment, and the narrative of Lloyd’s Bank demonstrated that a distinction fell to be drawn between a reverse surrender on the one hand and the exercise of a right conferred in the original lease on the other.

Economic reality

Lord Tyre, delivering the opinion of the court, observed: “The sum paid by the tenant to allow it to exercise the break option was part of the consideration received by the landlord for the taxable supply consisting of the lease of the premises. The analysis may be somewhat different where the landlord’s right to payment arises in terms of an agreement which post-dates the original lease, but the VAT outcome will be the same because the economic reality is the same. To treat such a payment as compensation falling outside the scope of VAT would not accord with the economic reality of the transaction.”

On whether the landlord had a legitimate expectation that VAT would not be charged, he said: “The passages in Lloyds Bank relied upon by the tenant would not have amounted to a sound basis for any legitimate expectation on the part of the landlord 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.”

He went on to say: “The guidance in relation to reverse surrenders, ie that payments by tenants to landlords to take back the lease are either exempt or, if the landlord had opted to tax, standard-rated, was (and remains) unqualified: there was nothing there to suggest that HMRC would treat payments provided for in the original lease as outside the scope of VAT.”

Lord Tyre concluded: “[The commercial judge] fell into error in regarding the answer as having been determined by the terms of HMRC policy recorded in Lloyds Bank, rather than by application of the relevant statutory provisions and authoritative case law. For the reasons we have given, we find that VAT was indeed ‘properly due’ on the break option payment. It follows that the option was not validly exercised by the making of a payment which did not include the VAT chargeable on it. The reclaiming motion must be allowed.”