HMRC announces new approach regarding VAT on contract terminations and compensation payments

HMRC has announced its long awaited new approach to the VAT treatment of early termination fees and compensation payments paid under a contract. 

Historically HMRC position had been fairly clear. Payments described as compensation were generally treated as outside the scope of VAT, while HMRC would only seek to charge VAT on a payment if it was not made pursuant to any contractual provision. 

Then in September 2020 HMRC changed its approach (in Revenue and Customs Brief 12 (2020) in view of certain EU case law (principally regarding the early termination of mobile phone contracts, though the principles from those cases were to be applied basically whenever a contract, including a lease, was terminated early).  HMRC thereafter treated early termination fees and cancellation fees made to a supplier as additional consideration for the goods or service which the supplier was supplying under the contract and therefore subject to VAT (regardless of whether the contract provided for early termination). To the annoyance of many, they also specified that the policy would be retrospective and that taxpayers who had not accounted for VAT upon receipt of such termination fees should make a voluntary disclosure to HMRC and seek to rectify the position.

Unsurprisingly this approach was met with widespread criticism and HMRC suspended the September 2020 guidance in January 2021 and noted that they would shortly revise their approach. Pending the next announcement, taxpayers could either treat the termination fees as further consideration for the contracted supply or go back to treating them as outside the scope of VAT.

HMRC has now published Revenue and Customs Brief 2 (2022) outlining how they will treat termination and similar payments for VAT purposes from 1 April 2022. In essence, not an awful lot has changed in that HMRC will likely view a sizeable majority of contractual termination payments as further consideration for the underlying supply of goods or services for which the customer originally contracted. So if the contract is subject to VAT then so will the termination payment. This is broadly in line with the September 2020 approach, although HMRC new guidance emphasises the need for a direct and immediate link between the amount paid by the customer and the supply by the supplier and does note that where a fee to terminate is punitive in order to deter a breach of contract, VAT would not arise. The guidance gives the example of a car which is hired and is returned one day after the agreed return period, occasioning a late return fee.  The fee is generally designed to deter late return of the car and to compensate the owner for the additional use of the car. The charge will be subject to VAT as it is for the supply of the car. The customer is aware of the additional charge and how it would be calculated. 

A further specific point in the new guidance is that dilapidations payments made pursuant to a lease (to compensate a landlord if a leasehold property is not returned in the appropriate condition) will generally be treated by HMRC as outside the scope of VAT unless there is an attempt to shift value passing from the tenant to the landlord away from rent and into dilapidations in order to avoid paying VAT. Its position on payments to end a contract which are made outside the terms of the contract remains that such payments are likely to be subject to VAT.

HMRC has said that all businesses must apply the new VAT treatment by 1 April 2022 (including taxpayers who may have had a specific ruling from HMRC saying that the relevant fees are not vatable).

This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.