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HMRC Changes VAT Rules for Early Contract Termination Fees

HMRC Changes VAT Rules for Early Contract Termination Fees Background Decorative Image

Amidst the turmoil of COVID-19, HMRC has suddenly reversed its position on early termination fees, announcing such fees are now subject to VAT. In addition, it is taking the controversial position that this change in policy is retroactive, with no clarity on how far back taxpayers must go to correct the position.

Background

On 2 September 2020, HMRC published Revenue and Customs Brief 12 (2020) and updated guidance to treat early contract termination fees, including payments on a breach or withdrawal of a contract and liquidated damages, as subject to VAT.

Historically, HMRC’s published view was that payments charged to customers to withdraw from agreements to receive goods or services were not generally for a supply and were therefore outside the scope of VAT.

Following two recent decisions of the European Court, however, HMRC has reversed its position.1

Whom does this affect?

Businesses making taxable supplies for VAT purposes that charge recipients of such supplies to withdraw from the relevant contract will be affected by the change in position. Most payments arising from an early termination of such contracts (e.g., liquidated damages or break fees) will now be treated as consideration for a taxable supply and therefore be subject to VAT.

Adding to the burden and uncertainty, HMRC has not made it clear how far back businesses must go to account for VAT on past payments, or whether interest and penalties will apply to taxpayers seeking to reverse their filing positions. As a consequence, businesses may rightly feel aggrieved on the basis that they had a legitimate expectation that HMRC would follow its published guidance.

In considering whether payments will now be subject to VAT, HMRC has stated it is irrelevant whether:

  • the original contract has a right to terminate (previously, HMRC distinguished between contracts that contained a right to terminate and those that did not);
  • such payments are described as compensation or damages; or
  • the amount payable is equal to the amount that would have been due had the contract been fulfilled.

Only where there is no direct link between a payment and a supply of goods or services will the payment be outside the scope of VAT.

Looking ahead

Given the events of 2020, it is likely that there will be more situations than usual in which contracts are being terminated early. On the basis of HMRC’s updated guidance, businesses will need to carefully consider whether payments arising in connection with such an event will be subject to an additional 20% VAT. The impact will be particularly unwelcome to those businesses that are not able to recover their VAT costs in full.

It is hoped that HMRC will quickly clarify a number of questions resulting from its surprise announcement. In the meantime, businesses that have failed to account for VAT to HMRC on early termination fees should consider whether they have a legal obligation to amend past returns. Such businesses should also review their commercial agreements to evaluate whether and how the allocation of VAT on early termination fees is specifically dealt with in such agreements. Going forward, businesses should explicitly address the allocation of VAT in their contracts as well as in agreements resolving contractual disputes.

Should you wish to discuss the VAT treatment of any particular payment, please do reach out to Andrew Callaghan or Simrita Chadha.

1 MEO – Serviços de Comunicações e Multimédia SA v Autoridade Tributária e Aduaneira (C295/17) and Vodafone Portugal – Comunicações Pessoais SA v Autoridade Tributária e Aduaneira (C-43/19).

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.