Thursday, 30 June 2011

Schedules Of Condition: For Better Or Worse

James McAllister, Director of The Dilapidations Consultancy, looks at the frequently misinterpreted wording surrounding the application of Schedules of Condition in leasehold repair covenants.

[Abstract]

Business tenants with the foresight to have obtained a Schedule of Condition at the outset of their lease may take some comfort in the fact that they have the ‘protection’ of documentary evidence as to the condition of the landlord’s premises at lease commencement.  What they may not know, certainly at the time of signing the lease, is just how much protection this might afford them; and as with all things legalese, it hangs on the wording.

This article explores the practical and legal implications when considering the interplay between the terms to keep in ‘no worse’ and ‘no better’ condition.

(Continued...)

For the full article, please email: info@dilapidationsconsultancy.com.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885 

e: info@dilapidationsconsultancy.com

Dilapidations & Break Clauses: Breaking The Rules

James McAllister, Director of The Dilapidations Consultancy, outlines the legal hurdles to be considered if signing or disposing of a business lease with regard to break clauses and dilapidations.

[Abstract]

Most businesses will occupy premises they do not own.  This requires the company or company owner to take a business lease where terms can vary from a matter of months to decades.  Traditionally, commercial property leases were 20-25 years, often known as the ‘institutional lease’, but the changing nature of business occupation over recent years, coupled with increasing economic uncertainty, has seen the average term of the business lease contract substantially.

Few commercial landlords now enjoy the luxury of a tenant signing a 10+ year lease; fewer still can take comfort in their new incumbent signing a lease for a significant term without the imposition of a break clause operational a few years in to the term.  More often than not, landlords will have to offer significant inducements, such as extended rent-free periods, reverse premiums or capital contributions for any improvement works the tenant may wish to undertake once they have signed on the dotted line.  This is endemic of the current climate and has strengthened the business tenant’s negotiating power like never before.  This has culminated in the simple fact that commercial leases of any sizeable term without a break clause provision are a very rare thing indeed. 

Aside from the already increasingly complex and onerous repairing obligations of a standard commercial lease, the hazards of improperly executing a break clause add to the potential pitfalls for the unwary and ill-advised business tenant.

(Continued...)

For the full article, please email: info@dilapidationsconsultancy.com.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885
 

e: info@dilapidationsconsultancy.com

Dilapidations & Fixtures: In A Fix

James McAllister, Director of The Dilapidations Consultancy, explores the legal implications for commercial business tenants who fail to remove their fixtures and fittings before their lease expires.

[Abstract]

The term ‘fixtures and fittings’ permeates everyday language, even outside the world of commercial business leases.  However, the definition of these seemingly innocuous words, and the wider implications they may have for tenants, deserves careful consideration.

Few tenants will occupy their leased premises without making some form of alteration.  This may be a basic necessity to allow the business to function, and may only take the form of additional power sockets and data trunking.  It may encompass partitioning, suspended ceilings and air conditioning, or in extreme cases, structural alterations.  Most retail tenants will have their own corporate fit-out requirements; image-conscious office tenants may even snub the landlord’s perfectly adequate decor in favour of plush carpets, vinyl wall linings and opulent reception areas.  All of which, to a greater or lesser degree, fall squarely under the ‘not to alter’ clause prevalent in nearly all commercial leases.  In some cases, this may be a strict prohibition on anything more than inserting a picture hook; in others, demountable and semi-permanent partitioning may be permitted without express authorisation from the landlord, subject, of course, to reinstatement at lease termination.  Even where a licence to alter is required, and subsequently obtained by the attentive tenant, rarely will permission be granted without some sort of reinstatement provision.

Thus, it is unlikely any commercial tenant will survive the term without having to make good their modifications regardless of how extensive they might be.  For the diligent few, this will be done in advance of their vacation and the termination date.  Others may see no value in taking their fixtures with them, perhaps even believing that they help to ‘enhance’ the demise for the fortunate landlord or their next tenant.  However, the way in which the law interprets what the landlord can and can’t recover within the ambit of a dilapidations claim gives a stark warning for all tenants who naively believe walking away from the property at the end of the term is the end of the matter.

(Continued...)

For the full article, please email: info@dilapidationsconsultancy.com.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885
e: info@dilapidationsconsultancy.com

Dilapidations & Loss Of Rent: Lost In Translation

James McAllister, Director of The Dilapidations Consultancy, explores the oft misunderstood Loss of Rent claim in dilapidations.

[Abstract]

Loss of Rent is perhaps the most misunderstood and misplaced aspect of any dilapidations claim.  This has become more prevalent in recent years, fuelled by the economic climate and an ever-increasing need for landlords to stem the inevitable loss they will suffer by owning a vacant property.  But is the loss of rent claim ever actionable? If so, when?

Many landlords, and indeed their surveyors, see the loss of rent claim as a means of compensating the landlord for the rental void that will invariably follow the outgoing tenant’s departure at the end of the lease.  This is most commonly applied in situations where the tenant vacates without fully observing their repairing obligations under the lease, leaving a dilapidations claim to be ‘negotiated’.  The landlord (ably encouraged by his surveyor) will usually include, as part of this claim, an allowance for ‘loss of rent’.  This allowance being a crude computation of the time in weeks it would take a hypothetical contractor to undertake the works the tenant should have done, multiplied by the weekly rent.  Depending on the extent of works claimed and the passing rent, this could range from being a minor embellishment to the original claim, or could even eclipse the core value of the building works altogether.  Some landlords and their poorly researched surveyors even opt to include loss of rent for the ensuing void period following vacation by the outgoing tenant. 

It is therefore not difficult to see why the loss of rent element of a claim is irresistible to landlords as a further tool for bolstering the claim; but it is perhaps equally clear to see why such a claim is so rarely successful.

(Continued...)

For the full article, please email: info@dilapidationsconsultancy.com.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885
e: info@dilapidationsconsultancy.com 

Wednesday, 16 March 2011

Dilapidations & Mediation: A Perfect Marriage?

James McAllister, Director of The Dilapidations Consultancy, considers the benefits of utilising Mediation as the primary method of dispute resolution in adversarial dilapidation claims.

Dilapidation claims in commercial property are on the increase; this is widely acknowledged by all leading practitioners in the field and was covered in some detail in our article 'Dilapidations On The Rise' [2011]. posted previously on this blog.  Fortunately, most claims are settled well before proceedings are issued and counsel appointed.  However, a fair few claims still suffer the recalcitrance or obstinacy of the associated parties and/or their ‘experts’, and so a courtroom battle will ensue.  The obvious disadvantage to this being that the associated legal costs will invariably outweigh the ‘value’ of the claim (i.e. the disparity between both positions) meaning the only victory may be of the Pyrrhic variety.

It is a well known fact that true ‘expert’ dilapidations practitioners have never been near a courtroom; this is testimony to their ability in either preparing a fair and reasoned claim from the outset, or, if defending, providing persuasive evidence to discredit their counterpart’s woefully exaggerated claim culminating in the shaking of hands on a figure that is nothing other than the true measure of loss.  Naturally, if the claim is accurate in the first place, and both surveyors are suitably versed in the legal formalities governing these matters, then the claim may well be settled in nothing more than a few letters and a single draft of a Scott Schedule.

Regrettably, most landlords and their have-a-go ‘expert’ advisers fail to grasp the simple principle that a terminal dilapidations claim is an allegation of breach of contract and the costs contained therein represent a claim in damages.[1]  They further overlook the fact that, in law, damages (unliquidated) is a remedy to compensate loss, and one cannot recover what one has not lost.  A generous application of common sense should be enough alone to halt the production of a highly inflated claim, which, taken to the extreme, could be tantamount to fraud.[2]  Whilst there have not been any reported cases of fraud in dilapidations so far, it is perhaps only a matter of time.

So for those claims that don’t seem to benefit from the appointment of two like-minded practitioners singing from the same hymn sheet, what practical alternative is there to having one’s day in court?

The obvious answer to this is Mediation.  As a recognised mechanism for dispute resolution the world over, mediation is fast becoming the primary method of ADR (alternative dispute resolution) and is infinitely preferable to litigation; and the reasons are clear to see.  Mediation offers a fast, effective and inexpensive way of obtaining a legally-binding agreement for the participating parties to conclude their dispute. 

There is, of course, a criterion to be met and not all disputes are ripe for mediation.  However, since mediation is most commonly applied to situations where the law does not provide an answer (e.g. the correct ‘value’ of liability) or a remedy, it provides a way for the disputants to reach a mutually acceptable settlement, bypassing the legal costs associated with the less-appealing alternative. 

It also means agreement can be achieved in a timely fashion leaving the parties to return to their core-business activities without losing weeks, months or even years of valuable (and irrecoverable) time which would inevitably be swallowed up by litigation; this says nothing of the stress that would also be avoided.

Since the Woolf reforms to the Civil Procedure Rules in 1999, disputing parties are actively encouraged by the courts to co-operate and consider the use of ADR prior to proceedings,[3] especially mediation.  More significantly, where the dispute arises out of contract, and where ADR is an express resolution mechanism within the contract, the court can enforce the binding nature of the ADR clause before taking the matter further.[4]

It should be made clear that mediation is a voluntary process[5] and both parties must come to the table of their own accord.  Unlike litigation, one party cannot force mediation upon the other simply because it suits them,[6] although it should be noted that if the dispute does proceed to court, woe betide the party that declined mediation when offered.[7]  It should, however, be reiterated that mediation is not necessarily appropriate for all disputes, and in such cases, could be legitimately refused without reprimand (or risk of an adverse costs order), particularly where the law does provide an answer and a remedy, or where there was ‘no realistic prospect of success’.[8]

Mediation is also private and confidential and does not exist in the public domain; this keeps the dispute and all its gory details behind closed doors.  One often overlooked benefit is that mediation has the ability to preserve relationships whilst the dispute is negotiated and settled, which is of utmost importance in certain business relationships which litigation has the tendency to destroy.

Above all, mediation can be seen as a ‘win-win’ outcome to a dispute, as opposed to the more mercenary ‘win-lose’ concept of traditional dispute resolution.  When taking in to account the cost of litigation to the respective parties, ‘lose-lose’ is perhaps closer to the truth since even the winning side will rarely recover all of their outlay.  The positive ‘win-win’ attribute of mediation exists on the simple premise that the settlement decision is not enforced upon the parties by a neutral arbiter; rather it allows the parties to reach their own terms and conditions for settlement, of course ably assisted by the Mediator who is simply the neutral party facilitating and nurturing the negotiations towards agreement.  In dilapidation claims there will generally always be a value (unless pending demolition of the subject property is a factor), so assuming the parties get to a point where that value is acceptable to both, then the objective of the exercise will have been achieved.  If not, then it will be clear that the impasse is fuelled either by one party refusing to accept the true extent of their liability, or the other seeking to recover more than they are entitled to.  If the impasse cannot be resolved by the Mediator (and there are a number of techniques at hand to overcome this) then it will be the parties who have failed leaving them to have their day in court after all.

So, dilapidations is perhaps the perfect type of dispute for a mediated settlement where the efforts of their representatives, ‘expert’ or otherwise, fail during initial negotiations.  Most mediation sessions can be arranged within a few weeks and can also be concluded in a single session at a cost of only a few hundred pounds per side.  If successful, the parties walk away, not only relieved at finally reaching a conclusion, but both feeling they have succeeded.  They will also have a legally-binding souvenir of their efforts; naturally, this can always be enforced in court further down the line if one side fails to keep their side of the bargain.

As always, early professional advice is invaluable, particularly where the dispute appears to be fractious from the outset and may therefore benefit from a mediated outcome whilst the relationship between the parties is still amicable.  It is worth reiterating that mediation is voluntary and requires the agreement of both parties; if this can be achieved, then the first hurdle will have been overcome towards successful resolution.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited and is a Certified Commercial Mediator and founder of PropertyMediator.co.uk.
tel: 0844 2510885
e: info@dilapidationsconsultancy.com 


[1] Unless implementing a Landlord’s ‘self-help’ clause during the term pursuant to the provisions set out in Jervis v Harris [1996] Ch 195; [1996] 1 All E.R. 303, where the Landlord’s costs are recoverable as a debt rather than damages.
[2] Section 2, Fraud Act 2006.
[3] CPR Rule 1.4(2)(e).
[4] Cable & Wireless Plc v IBM United Kingdom Ltd [2002] EWHC 2059 (Comm).
[5] Halsey v Milton Keynes General NHS Trust and Steel v Joy & Halliday [2004] EWCA Civ 576; [2004] 1 W.L.R. 3002.
[6] Wyatt v Maxwell Batley [2002] EWHC 2401 (Ch).
[7] Dunnett v Railtrack Plc [2002] EWCA Civ 303.
[8] Hurst v Leeming [2002] EWHC 1051 (Ch).

Wednesday, 16 February 2011

Dilapidations On The Rise

James McAllister, Director of The Dilapidations Consultancy, looks at the trends that have fuelled the recent increase in Dilapidation Claims in commercial leasehold property.

Dilapidations is a fact of life in commercial leasehold property.  As an area of Landlord & Tenant law, dilapidations, as a concept, has been around for hundreds of years allowing the courts to put to test everything from the meaning of repair to valuing the impact of disrepair, and an awful lot in between.  In recent years, the volume of dilapidation claims has been on the increase, but so too have the efforts of those professionals who deal with them in promoting transparency and fairness; the objective being to reduce the number of claims proceeding to litigation and eliminate fraudulent abuse of the process.

The current economic environment  is, of course, a major contributor to the recent uptake in claims, but the trend has been shifting for much longer than this, as landlords have seen it as an end-of-lease ‘bonus’ and tenants have become more savvy about curtailing their otherwise open-ended liabilities.

Over the last few decades, the length of commercial leases has diminished.  The traditional ‘institutional’ 25 year leases, without an option to break mid-term, are all but gone.  These leases have been superseded with 3-10 year terms, usually with an early option to terminate by way of a break clause.  This, of course, is at the behest of nervous tenants who don’t want to over-commit when the longevity of their business cannot be guaranteed.  It also works for those few tenants in the fortunate position of anticipated expansion and not wishing to be saddled with a property they will soon outgrow.   The frequency of dilapidation claims has therefore increased against the general backdrop of falling lease terms and the prevalence of break clauses giving tenants an early opt-out.

However, the economic downturn over the last few years has become a more significant catalyst for the volume of dilapidation claims in circulation.  Struggling tenants who had the foresight to sign a lease with a break clause are opting to use this lifeline now more than ever.  This is much to the detriment of the landlord who perhaps had naively assumed a consistent income stream over the full term.  Those impecunious tenants without the luxury of a ‘get out of jail’ card only have the option of proposing a surrender, which will invariably be at the mercy of the landlord’s terms.  If the tenant is viewed as a strong covenant, then few landlords in the current climate will be agreeable to a surrender unless the deal on the table is too attractive to refuse, and where there is another suitable candidate waiting in the wings.  On the other hand, landlords are faced with a more awkward decision when a tenant they see as a ‘man of straw’ neither has the funds to table a persuasive surrender proposal, nor the means to continue paying rent to the end of the lease term.  If they disappear, the landlord will be left to do some wound licking as a dilapidations claim will be a futile exercise.

Break clauses, of course, do not come without warning.  Several dilapidation claims arising out of the tenant’s formal request to break from the lease have been put before the courts, where the successful operation of the break clause is subject to certain conditions, and where those conditions, in the eyes of the landlord (and his eager lawyers) have not been met.  As such, tenants who labour under the belief that a quick lick of paint to the premises will suffice may be in for an unpleasant surprise when they learn of the conditionality of their break clause and the material nature of their outstanding covenant breaches.  Failure to comply may mean the lease remains extant, an expensive mistake if the tenant has already signed a lease on new premises.  Accordingly, ‘conditionality’ and ‘materiality’ have been the source of much debate before the courts, and as always, the precise wording of the lease in each case is central to the tenant being able to escape unscathed: Fitzroy House Epworth Street (No. 1) Ltd v The Financial Times Ltd [2006].[1]

The above has considered Terminal Schedules of Dilapidations, which are prepared towards the end of the lease term, or where a break clause is being operated.  This would also be applicable where the tenant is looking to surrender the lease, although a ‘Dilapidations Assessment’ is the usual tool to facilitate negotiations.  In terminal dilapidation claims, the landlord’s primary prerogative is to obtain a monetary settlement from the tenant as damages or await the tenant’s yielding up of the premises in full compliance with their obligations under the lease.  Any damages claim is, of course, subject to limitations, both at common law and under statute. 

The common law assessment for damages is essentially the cost of undertaking the works: Jones v Herxheimer [1950].[2]  However, few landlords reunited with their empty premises will wish, or have the means, to forward-fund the works they allege the outgoing tenant should have performed simply in order to substantiate their loss towards a successful claim in damages.  So the usual outcome is that the landlord awaits the cheque from the defaulting tenant and then sets about implementing the works.  More often than not, the landlord will bank the cheque and then place considerable pressure on his lettings agent to market the premises in its un-repaired state.  The loss will inevitably be sustained further down the line, either by way of a reduced sale price or rental reduction, or other such inducements necessary to attract a would-be tenant to take a property in less than perfect condition.  Notwithstanding this, few commercial landlords would presently pass up the option to have the flexibility and comfort of certain liquidity, leaving any concerns over the implementation of the repairs to another day.

Whilst the principles of damages are well established in that the landlord cannot recover what he has not lost, Section 18(1) of the 1927 Landlord and Tenant Act also states that the landlord cannot recover more than the amount by which the value of the property has been diminished by virtue of the repairs.  This essentially places a ceiling on the value of any claim for damages pertaining to breach of the repair covenant.  The second part of this section also states that if the landlord is to demolish, or substantially alter the building at or shortly after lease expiry, no damages shall be recoverable for those repairs ‘rendered valueless’.  The most common instance where this applies is when landlords seek to extend the remit of the ‘dilapidation works’ to include general enhancements to their property, often obviating the need for certain repairs claimed against the tenant nonetheless.  This part of the Act affords tenants some protection by precluding any claim for those repairs now superseded by the landlord’s wider proposals.  Clearly, knowledge is power, so without incontrovertible evidence as to the landlord’s intentions, a tenant claiming relief on this basis will be hard pressed to build a case.

In light of the economic downturn, landlords are also looking to simply protect their investment and force the tenant to observe their repairing obligations during the lease term, rather than wait to expiry to claim damages.  This is particularly important where the tenant is indeed a man of straw and the landlord would rather they attend to the roof leak and the rotten window frames now than risk being left with the problem should the tenant fold.  As such, Interim Schedules of Dilapidations are also more common now than ever, and landlords are increasingly making full use of the self-help provision commonly found in modern leases.  This is often cited as a ‘Jervis v Harris’ clause after the celebrated 1996 case,[3] which gives landlords a seemingly cast iron fallback position should the tenant fail to adhere to the landlord’s Repairs Notice.  Usually served by the landlord’s solicitor, and giving the tenant a strict timeframe for compliance (as stated in the lease), the onus is then firmly placed on the tenant to deal with the repairs within the stated timescale, or risk the landlord re-entering with his own contractors before sending the tenant the bill.  The bad news for tenants is that this is charged as a debt rather than damages and can therefore be recovered as rental arrears.  However, landlords (and their legal advisors) need to exercise caution, taking care to observe the specific terms of the lease and avoiding claims for non-repair items, or indeed requesting certain works that would be detrimental to the tenant’s business: Hammersmith & Fulham London Borough Council v Creska Ltd (No. 2) [2000].[4]  This may involve the costly pursuit of an injunction for access and a potential counter-claim for breach of the ‘quiet enjoyment’ clause.

Surveyors practicing in the preparation and negotiation of terminal dilapidations claims are now encouraged to abide by the Property Litigation Association’s ‘Dilapidations Protocol’ (or to give it its full name: ‘Pre-Action Protocol for Claims for Damages in relation to the Physical State of Commercial Property at the Termination of a Tenancy’).  Whilst not mandatory, it would be unwise to stray from ‘best practice’ since compliance with this protocol is likely to be considered should a claim be litigated given that its principle objective is to promote transparency and efficiency in settling claims, thereby keeping them out of the courts. 

Introduced in 2002, and now in its 3rd edition, the Dilapidations Protocol has succeeded to some extent in reducing the number of exaggerated damages claims in dilapidations, however, those surveyors who ‘dabble’ in this complex area of property law often fail to grasp the primary purpose of a Schedule of Dilapidations, and what can and what can’t be claimed.  Accordingly, many inflated schedules and unsubstantiated claims remain in general circulation, perhaps seen by the ill-informed landlord as a sure-fire way of squeezing every last penny out of an already desperate tenant. 

As landlords have become more aggressive in pursuing tenants, be it mid-term or at expiry, tenants have become equally robust in defending their position, or appointing a specialist dilapidations consultant to do so on their behalf.  Those savvy tenants, who have usually had their fingers burnt in the past, are only too aware of the potential financial ramifications of shirking their obligations; so they will either comply or build a good case to defend their position.  Those taking on premises in far from perfect condition will seek to mitigate the magnitude of any future claim by putting measures in place before the lease is even signed.  This includes careful drafting of the repair, decoration and reinstatement clauses, and where the landlord is agreeable, engrossing a detailed Schedule of Condition (with photographs) to use as an evidential benchmark for the pre-existing condition.  This must be referenced in the repair clause of the lease and is therefore pivotal to the standard of repair expected of the tenant going forward.  Tenants who believe that their own collection of photos taken when they first occupied will serve the same purpose may be sorely disappointed.  If the photographs, and any supporting text, are not referenced in the lease, it may be of little assistance in later defending their position.

In summary, the recent economic conditions have conspired to increase the frequency of dilapidation claims, but also polarise the respective positions of landlord and tenant as each becomes increasingly truculent in defending their stance, and indeed their business.  After all, there can be a lot at stake.  Dilapidations will continue unabated all the time tenants sign leases with a repairing obligation and then fail to do what is required of them.  And disputes will continue all the time landlords choose to exaggerate claims seeking to recover more than they are entitled to.  The key to keeping such disputes away from costly litigation is simply to appoint the right consultants to deal with the matter early on; that way, fairness and reasonableness might just prevail.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885
e: info@dilapidationsconsultancy.com 

[1] [2006] EWCA Civ 329; [2006] 1 W.L.R. 2207; [2006] 2 All E.R. 776.
[2] [1950] 2 K.B. 106; [1950] 1 All E.R. 323.
[3] [1996] Ch. 195; [1996] 2 W.L.R. 220; [1996] 1 All E.R. 303.
[4] [2000] L. & T.R. 288.

VAT On Dilapidations: The Taxing Truth

James McAllister, Director of The Dilapidations Consultancy, sets the record straight on the correct treatment of VAT in dilapidation claims.

Introduction

Let’s start with a fact: Dilapidations is outside the scope of VAT as far as HM Revenue & Customs are concerned.  So there we have it, VAT need not feature in dilapidation claims and settlement agreements.  If only it were that simple.

Whilst VAT technically has no place in dilapidations, for reasons that shall become clear, there are instances where an allowance for VAT can legitimately be included, despite HMRC’s seemingly clear and robust view on the matter.

Damages v Supply of Services

The position of HMRC on VAT in dilapidation claims is set out in section 10.10 of Notice 742 (Land and Property).  This is because it is a payment in settlement of damages and not ‘consideration’ in return for a ‘supply’ for VAT purposes.  This stands to reason: a tenant paying the Landlord an agreed sum for having failed to return the property in the condition they had covenanted under contract, is not, therefore, paying the Landlord in return for ‘supply’ of goods and services.  This is irrespective of the ‘elected’ VAT status of either the Landlord or the Building.

So when does VAT apply to dilapidations claims?  Whilst VAT never actually applies to dilapidations, in reality there are situations where an allowance for VAT can be included on the settlement figure, known as ‘compensation in lieu of VAT’.  This principle can be applied where the Landlord is genuinely at risk of suffering an otherwise irrecoverable loss to the value of VAT on any work he undertakes through the tenant’s default, but will, of course, depend on the elected status of the building.

VAT Status – The Building

Looking firstly at the VAT status of the subject building, all Landlords have the option to keep the building exempt (aka ‘unelected’) or to waive the natural exemption and thus ‘elect’ the building for VAT; this is also known as ‘opting to tax’.  The tenant will know the VAT status of the building from the outset since they will either pay VAT on their rent or they will not.  This is the simplest way Surveyors negotiating dilapidation settlements can adduce the VAT status of the building.

Building: Exempt

Where the Landlord has retained the exemption, meaning no VAT was charged on the rent, and assuming the tenant failed to deal with any dilapidation works prior to lease expiry, then the Landlord may wish to undertake the claimed works himself.  On the basis the building is exempt from VAT (no VAT charged on rental income) the Landlord will not be required to file a quarterly VAT return in which ordinarily any VAT incurred on the payment of legitimate business related expenses (known as input tax) can be offset against VAT owed to HMRC where charged on the supply of goods and services, i.e. rent (known as output tax).  Accordingly, the exempt status of the building will mean that any VAT the Landlord incurs on materials and labour in undertaking the works is effectively lost as it cannot be offset against output tax. 
In dilapidations parlance this is deemed  to be an ‘irrecoverable loss’.  This loss then needs to be addressed or else the Landlord will have incurred extra expense resulting from the tenant’s failure to observe their repairing obligations.  The value of this loss (currently 20%) can then be recovered from the tenant within the dilapidations settlement as ‘compensation in lieu of VAT’.

Building: Exemption Waived

Conversely, if the Landlord has ‘waived the exemption’, and in so doing charges VAT on rent, then he will be in a position to offset VAT on any subsequent works expenditure (input tax) against VAT owed to HMRC on any income derived from the property (output tax).  Therefore, no loss is suffered for any VAT outlay on the works the tenant ought to have undertaken, and as such, ‘compensation in lieu of VAT’ cannot be added to the dilapidations claim as an irrecoverable loss.

VAT Status – The Landlord

Contrary to the belief of many Surveyors, the VAT status of the Landlord is irrelevant as far as the treatment of VAT on dilapidation claims is concerned.  The Landlord may be personally unregistered for VAT purposes, but might hold the property under a limited company for that property alone, and in so doing, opt to register the building for VAT.  Each building is therefore unique and sweeping generalisations as to the applicability of compensation in lieu of VAT to dilapidation settlements based on the registered status of the Landlord should not therefore be made.  There is one exception, however, and that is financial institutions.  Some organisations fulfil the role as Landlord through either freehold owned property stock or as head tenant where the regulated status of their core financial business means they are unable to claw back VAT on any works expenditure whatever their status, or indeed the elected status of the building.  In those circumstances, the inability to offset input tax against output tax, even where exemption has been waived, will mean VAT does present a genuine loss which is likely to be included in any dilapidations settlement.

Realistic Prospect of Implementing Works?

Whether the works to remedy the claimed breaches have been done, might be done or are unlikely to ever be done are all central to the issue.  The difference between whether the works are likely or unlikely to be done will have a significant impact on the eligibility of the Landlord to successfully claim compensation in lieu of VAT on the settlement, provided of course the aforementioned criteria is also met.  It stands to reason that if the Landlord has absolutely no intention of undertaking any such works post-lease expiry, then there will be no incurred ‘irrecoverable loss’ in the form of VAT, so the claim should not include for it: Elite Investments v TI Bainbridge Silencers Ltd (No.2) [1987].[1]  It is worth noting, that this does not preclude the Landlord from successfully claiming the remainder of the dilapidations damages, assuming loss has been proven elsewhere.  It is anticipated that in the absence of any forthcoming information from the Landlord, the burden of proof will fall upon the tenant to demonstrate that the likelihood of the Landlord getting his hands dirty is fanciful, until the passage of time speaks for itself.

If, on the other hand, the Landlord is able to demonstrate a genuine intention to undertake the works, or better still, having already carried them out, then the additional claim for compensation in lieu of VAT on top of damages for the works is likely to be enforceable as a legitimate basis for compensating loss: Drummond v S&U Stores [1981][2] and Sun Life Assurance Plc v Thales Tracs Ltd (formerly Racal Tracks Ltd) [2001].[3]

Accounting For VAT in Dilapidations

The above sets out the basis upon which VAT can be included in dilapidations settlements, which is fine in principle, but a further hurdle arises when it comes to the practicalities of raising the invoice.  Unless the settlement has been agreed on a handshake with a cheque to follow, most dilapidation settlements, certainly among large commercial organisations, will need to be processed through the accounts, usually culminating in the raising of an invoice.  The problem then arises when the VAT column awaits completion, when, of course, the claim was settled on the basis of a lump sum in ‘full and final settlement’.  Obviously, if the Landlord has legitimately claimed VAT on the settlement then there will be no VAT entry on the invoice since the Building will not be an ‘elected’ entity.  As stated above, the ability to add VAT to the settlement arises out of the Landlord having no other means of offsetting or recouping this loss.  Equally, if the Landlord is expecting to apportion part of the settlement as VAT on the invoice (i.e. ‘elected’ for VAT) then the chances are he shouldn’t be claiming it in the first place through the ability to offset input tax against output tax.

The real complication arises where the invoice is being raised either by a management company or agent on behalf of the Landlord, or where the Landlord’s own holding company is VAT registered and is processing the accounts of an interest that isn’t registered, suddenly the VAT figure is difficult to position.  Where the Landlord and their business interest is unregistered, this is quite simply a single lump sum figure and VAT need not be mentioned.  Where the Landlord is registered and the building is unregistered then a lump sum figure without a breakdown for VAT may not be possible, so the total claim may need to be ‘netted back’ accordingly.  This adds a further problem in that the accounts will then show VAT on income (output tax) thereby creating an obligation to pay HMRC when the whole purpose of its recovery was to compensate the Landlord (as far as the unelected building is concerned) for the inability to recover VAT on works expenditure by any other means.

Therefore, careful consideration needs to be given to the invoice procedure, and where the process is likely to be complicated, as above, it is advisable to have an alternative invoice arrangement or statement for the purpose of the dilapidations settlement, which after all, is settlement of damages rather than supply of goods and services.

Listed Buildings

VAT in listed buildings adds a further potential complication in that repairs are standard rated, but improvements do not attract VAT, provided they follow consent and are undertaken by a VAT registered contractor.  However, improvements are unlikely to feature in a dilapidations claim, unless as a natural consequence of repair (Minja Properties Ltd v Cussins Property Group Plc [1998]),[4] or where necessary to achieve a ‘once and for all’ cure to an ongoing disrepair (Elmcroft Developments Ltd v Tankersley-Sawyer [1984]);[5] thus repairs will be treated for VAT in the normal way, and subject to the conditions set out above.

Conclusion

VAT should not therefore be considered as a foregone conclusion on each and every dilapidations settlement.  For compensation in lieu of VAT to be properly administered and legitimately claimed, due consideration should be given to the elected status of the building, whether the works are likely to be done, and whether the status of the Landlord means the cost of VAT on the implementation of works would amount to a loss irrecoverable by any other means.

It is important to bear in mind the principle in all dilapidations claims settled by way of damages: the Landlord cannot claim what he has not lost.

© 2011 The Dilapidations Consultancy Limited

James McAllister is a Director of The Dilapidations Consultancy Limited.
tel: 0844 2510885
e: info@dilapidationsconsultancy.com 

[1] [1986] 2 E.G.L.R. 43; (1987) 283 E.G. 747.
[2] [1981] 1 E.G.L.R. 42; (1980) 258 E.G. 1293
[3] [2001] EWCA Civ 704; [2001] 1 W.L.R. 1562; [2002] 1 All E.R. 64.
[4] [1998] 2 E.G.L.R. 52; [1998] 30 E.G. 114.
[5] [1984] 1 E.G.L.R. 47.