Failure to follow lease rules can prove costly - Eilidh Smith

A ruling by the Inner House of the Court of Session has highlighted the need for parties to take care to understand their contractual obligations when seeking to exercise rights under leases.

The court ruled that Kuehne+Nagel Limited’s failure to pay VAT on a sum due to its landlord, Ventgrove Limited, when giving notice of its intention to exercise its lease break option, rendered the notice invalid.

The 10-year lease commenced in 2016 and was subject to a break option which entitled Kuehne+Nagel to terminate the lease after five years. To exercise the option, the tenant was required to give notice and to pay the sum of £112,500 “together with any VAT properly due thereon”.

Kuehne+Nagel issued a break notice and paid the landlord £112,500. Ventgrove rejected the notice as invalid because Kuehne+Nagel had failed to pay a total of £135,000 (£112,500 plus VAT).

Eilidh Smith, Solicitor and business dispute specialist at Pinsent Masons

Ventgrove raised an action seeking declarator that the break notice was ineffective and that the lease, therefore, continued. At first instance, the court found in favour of Kuehne+Nagel but the Inner House upheld Ventgrove’s appeal.

Lord Tyre, giving the opinion of the court, described the requirement to pay “any VAT properly due” in the contract as “explicit and unequivocal”. The payment, or not, of VAT therefore had significant consequences for the parties. If the option was not exercised correctly, the lease would not terminate at the break date and would continue for a further five years.

The main question for the court was whether VAT was “properly due” on the break option payment, as a matter of law. If VAT was due, the court was asked to consider whether the landlord had a legitimate expectation that HM Revenue & Customs would treat the payment as taxable.

Lord Tyre concluded that the termination payment was consideration for a taxable supply of land and was therefore chargeable to VAT. It held that where VAT is payable on an underlying contract, such as in respect of the lease and payment of rent, a change in that relationship – i.e. the break – is subject to the same treatment. As a result, the court held that VAT was properly due on the break option payment.

It is not clear what consideration the tenant gave to the wording “together with any VAT properly due thereon” in the break clause. Regardless, the consequence is that, subject to other legal arguments to follow, the tenant issued an ineffective break notice and will remain bound by the lease for the remainder of the term.

This has obvious consequences and underlines how important it is that such provisions are carefully considered both when they are drafted, as to whether it really is necessary to include such wording, and then when the right is being exercised, as to what exactly is required of parties.

Kuehne+Nagel is now seeking to pursue an argument that Ventgrove is prevented from arguing that the notice is ineffective on the basis that it, allegedly, made representations that the sum paid, excluding VAT, was the correct sum prior to the notice being issued. This highlights that it is equally important that the party who is to receive any notice pays close attention to the contractual provisions.

Eilidh Smith, Solicitor and business dispute specialist at Pinsent Masons