VAT – HMRC change stance on termination payments and compensation

VAT – HMRC change stance on termination payments and compensation

It used to be believed that where a contract includes a customer payment which is either compensatory or a penalty for the early termination of a contract, the payments were outside the scope of VAT as they did not secure any supply/benefit in return.

However, this no longer appears to be the case!

HMRC’s recent Business Brief 12/20 has set out revised guidance following two key cases involving Telecoms providers in the European Court (i.e. Meo and Vodafone Portugal).

In the past, HMRC’s stated position followed the outcome of cases such as Holiday Inns, Croydon Leisure and Lloyds Bank which stated ‘there is no supply for VAT purposes of “the right to terminate” or other such service where a contract originally contains a clause allowing the parties to terminate early in lieu of compensation for perceived losses arising from the termination’. HMRC stated this was not the case where the payment was not envisaged in the original contract or the payment was to waive a notice period; such payments were typically always seen as being for a separate VATable supply.       

In Meo and Vodafone Portugal, the courts found that where a telecoms contract permitted the early termination by the customer in return for a prescribed level of payment, the payments were in fact nothing more than consideration for the supply of the underlying services i.e. telecoms services. This was found to be the case regardless of the description of the payment which was not relevant. Simply defining the payment as compensatory or as a penalty did not result in it being outside the scope of VAT.

What does all this mean?

HMRC has stated that any business which has received a previous ruling from HMRC which contradicts the above guidance must now treat such payments as VATable going forward. What is of concern is that HMRC are suggesting that their previous public guidance in this area is not clear and cannot be relied upon by businesses for past periods. Most businesses, particularly those with end consumers as customers may now find it difficult to pass a VAT charge on.

A number of organisations and trade bodies are understandably unhappy about the matter and are engaged in dialogue with HMRC. HMRC may be ‘rowing back’ slightly as we understand they have decided to hold off from operational staff pursuing underpaid VAT for the time being and have agreed to provide clearer guidance going forward. They are also reconsidering whether businesses have a ‘legitimate expectation’ to rely upon the previous guidance in this area to remove the need to bring VAT to account.             

This issue potentially affects telecoms providers, construction firms (liquidated damages), other leasing businesses and property landlords, all of which traditionally have compensation and termination payments included in their customer contracts/leases and may not have accounted for VAT on them.

In the property sector (rentals in particular), contracts/leases normally have provisions for a multitude of additional charges and some may have previously been treated as compensatory and outside the scope of VAT. These include, dilapidations, determinations, damages and deposits. Where the underlying lease/supply is VAT exempt, the issue will be less problematic but there could certainly be an issue for landlords making VATable supplies of commercial properties. Old leases/agreements may not allow the addition of VAT to such charges and any additional tenant/landlord cost in the current environment is unlikely to be welcome.

We recommend that affected businesses confirm how this affects them. For further assistance on the areas raised in this insight, or to discuss in more detail, please speak with one of the specialist VAT partners at Azets.

Head of VAT - Scott Craig

UK North - Veronica Donnelly

UK South - Andy Dawbarn