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Dilapidations demystified: accounting, tax and VAT implications

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If you have entered into a lease agreement to rent commercial property, it is common for the lease to include a dilapidations clause. Typically, these clauses will state that the tenant has to restore the property to the same condition it was in when the lease began.

Dilapidations can vary and could be quite expensive if structural changes have been made.

Whether these costs should be recognised in the accounts tends to be considered when a lease is nearing completion, as this tends to be when thoughts turn to what liabilities may arise.

However, it may be that this should be a consideration at an earlier date.

From an accounting perspective, there are specific recognition criteria for provisions:

  1. Is there a present obligation resulting from a past event? The past event would be the date that any alterations or damage takes place. An obligation would be present if this was specifically contained in the lease agreement.
  2. Is there likely to be a transfer of economic benefits? Is it more likely than not that the company will have to pay to settle the obligation?
  3. Reliable estimate – can the amount of the obligation be reliably estimated?

If all of the criteria are met, then a liability should be recognised on the balance sheet.

Audit impact

From an audit perspective, the following would be reviewed:

  • Is the provision material to the financial statements?
  • The lease agreement would be reviewed to determine if there is an obligation and when this crystallises.
  • Professional scepticism would be applied to the best estimate – i.e. have third-party quotes been obtained to support the amount payable to carry out the works?
  • If all three criteria have not been met for a provision, is a contingent liability disclosure required?

Tax impact

Provisions for dilapidation costs are generally tax deductible when they are recognised in the accounts, as long as they are not capital in nature.

HMRC specifically does not allow deductions for the following on the basis that they are capital in nature:

  • Rebuilding the leased premises
  • Restoring demolished portions by the tenant
  • Demolishing structures added by the tenant

If a tenant pays the landlord a payment instead of carrying out the dilapidations work themselves, (aka a “composition payment”), the tax treatment of this payment depends on the underlying costs that it is replacing. In the same way as for dilapidations costs themselves, a payment to the landlord will be tax deductible for repairs but not for capital costs.

The composition payment is considered compensation for not making repairs, not repair expenditure itself. It can be deducted when accounted for according to accounting standards, regardless of whether the landlord actually makes the repairs.

In summary, tax relief will be available for dilapidation costs that are not capital and will be deductible when they are recognised in the accounts. As such, it may make sense to recognise these as soon as the accounting treatment allows, as this will accelerate tax relief.

VAT impact

Dilapidation payments serve as the usual remedy for a tenant’s failure to fulfil their obligation to maintain their premises in good condition.

Genuine dilapidations fall outside the scope of VAT and have consistently been regarded as such. There was some uncertainty surrounding this treatment during 2020-2022. However, HMRC eventually clarified that genuine dilapidations do not attract VAT. Therefore, tenants should challenge their landlords if they try to charge VAT on dilapidation payments.

As you can see, dilapidations clauses can be complex, but we would recommend that consideration is taken throughout the lease period to understand how and when provisions for these costs should be recognised in the accounts and the associated tax position.

If you have any questions, please contact Terri Pierpoint in our specialist Property Team or your usual BHP contact.