New approach to VAT treatment of compensation/termination payments
The UK tax authority, HM Revenue & Customs (HMRC), began applying new guidance on the VAT treatment of compensation/early termination payments on 1 April 2022 and all businesses had to adopt the revised treatment by that date. Based on the revised policy, fees charged when customers terminate a contract early will be regarded as further consideration for the contracted supply and, therefore, subject to VAT. This change was prompted by a review of HMRC’s previous approach following the Court of Justice of the European Union’s decisions in Meo (C-295/17) and Vodafone Portugal (C-43/19), which highlighted that HMRC’s approach may differ from that applied in other jurisdictions.
The revised HMRC guidance, released on 7 February 2022, supersedes all previous policy in this area. Under the revised policy, more payments will be deemed to fall within the scope of VAT. Previously, compensation or termination payments were, in many cases, routinely treated by taxpayers as falling outside the scope of VAT, albeit that HMRC may have scrutinised the position carefully to assess whether the payments actually represented consideration for any further supply. HMRC published two sets of guidance in September 2020 and January 2021. The September guidance stated that many compensation/early termination payments should be treated as attracting VAT, and that this had retroactive effect. The January guidance stated that this policy would only be applied from a future date and, in the interim, taxpayers could choose which approach to take.
The revised policy released in February clarifies when HMRC will consider compensation/early termination payments to be payments for a supply and thus potentially liable for VAT. From 1 April 2022, HMRC expect that fees charged when a customer terminates a contact early will be treated as further consideration for the underlying supply and the appropriate VAT liability of the termination fee will follow that of the underlying supply. This will include situations where the payment exceeds the cost to the supplier of making the supply but is broadly equivalent to what would have been due from the customer had the contract not been terminated. The policy will apply regardless of whether the payment was envisaged in the original contract or came about as a result of a later agreement between the parties. It also applies even if the parties have specifically sought to label the payment as “damages” or “compensation.”
In HMRC’s updated guidance, it is only if the payment is “punitive” in size and designed to deter noncompliance that HMRC are likely to accept that the link to the original supply/contract has been broken, so it would be appropriate to treat the payment as outside the scope of VAT.
A significant exception to the above is a “dilapidation payment” made by a tenant to a landlord with respect to a lease of property. HMRC have indicated that they accept, for now, that such payments are likely to remain outside the scope of VAT but reserve the right to review individual cases. This is particularly likely if HMRC suspects there has been an attempt to obtain a VAT advantage by seeking to reduce the value of any taxable rents and increase the value of the dilapidation payment.
HMRC provide a number of examples in the guidance to illustrate the new position. These include the following scenarios using the example of a car hire business:
- “…if a car is hired for a period of a week and is due to be returned by, say 9am on a Monday but is not in fact returned until 5pm on the following Tuesday a charge for late return will normally be made. Such charges are generally designed to both deter the person hiring the car from bringing it back late and to compensate the hire company for the additional use. The charge will be subject to VAT as it is for the supply of the car, and the customer is aware that an additional charge will be made and how much that charge will be or how the charge will be calculated. Although the use goes beyond that which is agreed with the customer at the outset of the contract it is an additional hire fee…”
- “If the customer were to write off the car and the supplier charges a fee for doing so this will not be further consideration for the hire of the car. The supplier does not agree that the customer can write the car off, and this is not something one would normally expect as part of the supply. The contract may envisage the possibility that the car will be written off 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.”
The above changes are relevant to any business or person that enters into contracts relating to supplies that take place in the UK for VAT purposes and where a compensation/termination payment may arise. Any payments of this nature, or any contracts that contain a provision for such payments, should be considered carefully going forward. This is particularly the case if a business previously treated such fees and charges as being outside the scope of VAT, or if a VAT-averse organisation is expecting to pay such fees in future.
It has taken some time for HMRC to confirm its approach so there has been considerable uncertainty for taxpayers in this area. As indicated above, HMRC originally published revised guidance in September 2020 and January 2021 before settling on its final position, which is stated to apply prospectively only. As well as considering any future payments, any business that has made or received a compensation/termination payment relating to UK supplies since the September 2020 guidance was published may wish to review these to ensure that the VAT treatment applied remains valid. Similarly, any taxpayer relying on a ruling from HMRC that pre-dates the latest guidance will wish to review its position as such rulings are unlikely to remain valid.