HMRC Confirms Revised Policy on the VAT Treatment of Early Termination Fees and Compensation Payments
New guidance has been issued by HMRC setting out their new policy on the VAT treatment of early termination fees and compensation payments, supplanting heavily criticised guidance issued in 2020. Under the new guidance, businesses will be required to undergo a fact-sensitive analysis into whether there is a direct link between a payment and the underlying goods or services to which such payment relates, and whether the payment is consideration for the contracted supply. The new guidance is to be welcomed given that prior guidance from 2020 took too simplistic an approach; however, it requires a nuanced approach, and determining the correct VAT treatment will not always be straightforward. Due to the potentially significant financial consequences resulting from the wrong conclusion, businesses are encouraged to take appropriate advice on the VAT treatment of early termination, compensation and similar payments on a case-by-case basis.
On 7 February 2022 HMRC published Revenue & Customs Brief 2 (2022) and related guidance,1 setting out HMRC’s new policy on the UK VAT treatment of early termination fees and compensation payments. The new policy will apply from 1 April 2022.
The new Brief and related guidance replace Brief 12 (2020), which brought many termination fees and compensation payments into the scope of VAT by applying a wide interpretation of the CJEU decisions in MEO2 and Vodafone Portugal3 (which were contradictory to earlier HMRC policy in this area). Brief 12 (2020) was widely criticised for both its retrospective effect and the fact it was silent on the VAT treatment of a number of common transactions. In light of this criticism, it was suspended in January 2021 pending further review.
The new, revised HMRC guidance states that the majority of early termination/cancellation fees are liable to VAT if the underlying goods/services to which the fee relates are subject to VAT, but recognises that there will be exceptions to this general rule, such that a case-by-case approach will be required. Helpfully, the guidance confirms the VAT treatment of certain payments that are common in the construction and real estate sectors. The approach narrows the scope of payments that will be subject to VAT in comparison to the approach set out in Brief 12 (2020), but still represents a change from HMRC’s previous policy of regarding contractual termination payments and other payments described as “compensation” as outside the scope of VAT.
The basic principle: “Direct link” and “reciprocity”
As the revised HMRC guidance makes clear, for there to be a VAT-able supply, there must be a direct link between what is done by the supplier and the payment it receives, and reciprocity between the supplier and the customer. In other words, the supplier must provide something to the customer in return for payment (regardless of how that payment is described). As the guidance notes, the test of whether there is the necessary direct link and reciprocity should already have been determined with respect to a VAT-registered business’s normal income from a supply. Thus, the starting point will be to ask why other payments a supplier receives in connection with that VAT-able supply (however described) should not also be within the scope of VAT.
Payments for early termination of a contract
Historically, HMRC took the view that contractual termination payments and payments described as “compensation” were outside the scope of VAT. HMRC’s revised policy is to treat payments arising out of early contract termination as further consideration for the contracted supply, even if they are described as “compensation” or “damages”, where the payments are linked to that supply (which, they say, “will normally be the case”).
Thus, termination payments that arise from a contract which is broken due to a cause attributable to the customer, being charged to cover the costs to the supplier of making the supply available, or being equivalent to what would have been charged for the supply had it gone ahead as intended, will be further consideration for that supply, and so will be subject to VAT. (Note that this will be the case even when there is no pre-existing right to terminate in the original contract; so, for example, if a payment is made by a tenant for early termination of a lease where the lease does not provide for such early termination, the agreement to pay the termination payment may be treated as a variation to the lease and VAT would apply where the underlying lease is itself subject to VAT.)
As the guidance notes, however, an exception to this principle might be if a termination fee is set at such a high level that it is clearly punitive and is designed to prevent breach rather than to compensate for lost income; in that case, the link between that payment and the supply may not be sufficient to regard it as additional consideration for a supply, and it may be outside the scope of VAT. In determining the VAT treatment, therefore, the level of fee will need to be carefully considered in light of all the facts and circumstances.
Penalties and dilapidation payments
A payment described as a penalty may not be actually punitive, but instead may, based on economic reality, be further consideration for a supply. For example, when the amount of a late return penalty is the same as the agreed payment for the hire of an item, the penalty may be an additional fee for hire. Such charges are generally designed to deter the person hiring the item from bringing it back late but also to compensate the hire company for the additional use. Such a payment would generally be subject to VAT (if the underlying supply of the item is subject to VAT). But again, if the fine is substantial and punitive (rather than compensatory) it may be outside the scope of VAT, as the reciprocity needed to link it to the supply is lacking. The level of the fee for breaching the terms of the agreement comparison to the standard fee may be indicative of which category a particular fine would be in.
On the other hand, a penalty for damaging a hired item would not be further consideration for the hire of the item. The supplier generally does not agree that the customer may damage the item, and this is not something one would normally expect as part of a supply. The contract may envisage the possibility that the item will be damaged and provide for a fee to be paid should that eventuality arise, but this is not further consideration for the supply as the necessary reciprocity does not exist.
With respect to dilapidation payments in the land and property sector, HMRC have confirmed their continuing policy that these will normally be outside the scope of VAT, although they might depart from that view if in individual cases they find evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.
Breach by the supplier
Where a supplier (rather than the customer) breaches the terms of a contract, it may reduce the price it charges for the supply, as what is being supplied has been altered. This will result in less VAT being charged if the supply is taxable, and if the adjustment is made retrospectively the supplier must adjust the VAT they have accounted for. Price adjustments in these circumstances are common practice and if the customer is asked to pay less, the price has likely been reduced to reflect the lower value of what was actually provided.
If the price is not adjusted but instead the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered as a result of the breach, the payment will be outside the scope of VAT. This might happen where the knock-on effect of the supplier not fulfilling the supply as originally agreed results in substantive costs to the customer for which they seek recompense. The payment may bear little relation to what was provided, in which case the payment will not be sufficiently linked to the supply to be treated as reduced consideration; such a payment will be outside the scope of VAT. This type of payment is common under construction contracts, and it is reassuring to see the VAT treatment many will have adopted confirmed in the guidance. However, the distinction between price adjustment and liquidated damages set out in the guidance is not clear cut, and in many cases it may not be clear where the new boundaries lie.
Actions and timing
All businesses must adopt the revised treatment by no later than 1 April 2022. This includes any business that has received a specific ruling from HMRC saying that a payment is outside the scope of VAT. Any business that adopted the treatment outlined in Brief 12 (2020) and accounted for VAT on transactions now outside the scope of VAT may correct this on their next VAT return.
1 VATSC05910, 05920 and 05930.
2 MEO – Serviços de Comunicações e Multimédia SA v Autoridade Tributária e Aduaneira (C295/17).
3 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.