HMRC has revised the VAT treatment of early termination fees and similar compensation payments following recent CJEU judgments. HMRC states that this will impact anyone who charges their customers to withdraw from agreements to supply goods or services, but our view is that the impact is likely to be more extensive.
On 2 September 2020, with no apparent advance notice to stakeholders or affected industry groups, HMRC issued guidance confirming its view that many payments previously agreed by HMRC in public guidance and in written rulings to be outside the scope of VAT are, in fact, subject to VAT.
Furthermore, HMRC has stated that those taxpayers impacted should declare VAT in accordance with the usual timescales, ie the past four years, unless they are in receipt of a specific ruling from HMRC on the VAT treatment of specific types of payment.
What has caused HMRC’s change in view?
VAT is due on a supply of goods and services in the course of business by a taxable person for consideration. It has, therefore, been a longstanding convention in VAT that a supply can only occur where ‘something’ is supplied by way of goods and services and consideration is provided for it.
Many situations can occur where activities do not take place but, nevertheless, a payment is made by one party to another to compensate the other party for the supply not taking place. For many years HMRC has agreed that such payments are not in respect of a supply (because one was not made) and therefore are compensatory and outside the scope of VAT. The main authority for this was the 2007 CJEU case of Société Thermale d’Eugénie-Les-Bains (C-277/05) related to retained deposits for ‘no-show’ hotel bookings. HMRC’s previous (now deleted) guidance (VATSC06720) 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.'
However, there will be supplies where no such right exists and agreements have separately to be reached properly to terminate the contracts. This is so even if there is much talk of monetary ‘compensation’ in these agreements.’
This principle has been applied to matters such as liquidated damages in construction contracts, early termination fees and breaches of contract payments.
In more recent CJEU judgments, particularly the 2018 decision in MEO (C295/17) and Vodafone Portugal (C43/19), both related to termination payments, the CJEU has decided that the payments made by customers that were contemplated in the contract were to be treated as part and parcel of the underlying agreement to provide services and were consideration, even if described as penalties under national law.
In HMRC’s current view, payments that might or might not be compensation do not arise in a vacuum, and generally arise as a result of an underlying contract and, essentially, are further payment for the supply. This new approach is consistent with a similar change in policy effective from March 2019 related to retained deposits. In simple terms, HMRC sees payments made towards prospective services as being consideration, even if no supply actually occurs. HMRC’s revised guidance (VATSC05920) now states:
‘HMRC’s policy is to treat payments arising out of early contract termination as consideration for a taxable supply. Businesses must account for VAT on these fees. This applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached’.
What may remain outside the scope of VAT?
In HMRC’s current view, where there is no direct link between a payment and a supply of goods or services, the payment may be outside the scope of VAT: an example from its updated guidance is a payment made to farmers to cease milk production. This was not regarded as consideration because it was a payment for the wider good and not related to specific farmers’ supplies. In addition, genuine non-contractual payments made to recompense loss may still be outside the scope of VAT, but this is not 100% certain.
What is the impact?
When HMRC changed its view on retained deposits in December 2018, it announced that the revised treatment would apply from March 2019, and taxpayers could rely on the historic rules for payments before March 2019. Historically, it has been HMRC’s convention that when it changes its written guidance/policy, any amended guidance or policy does not have retrospective effect. However, the 2 September 2020 update simply set out that HMRC had changed its view based on CJEU judgments, and impacted taxpayers may need to declare VAT in accordance with the usual timescales. This means that a four year window applies. The only exception is taxpayers who had a specific written ruling on the VAT treatment, who must apply the new rules from 2 September 2020.
Applying the policy change this way is controversial and may, potentially, mean that, for example, a liquidated damages or contract termination payment received up to four years ago may now require VAT to be accounted for (based on 1/6th of the amount). In extreme examples, contract clauses may be silent on VAT or, even if VAT can be sought under contract terms, the debtor is no longer in business or refuses to pay.
BDO is seeking further clarification from HMRC on this policy change, especially on the retrospective nature of the change. In the meantime, if your business has received or made payments for contract termination, liquidated damages, lease agreements and breaches of contract since 2 September 2016, you should seek specific advice on the VAT status of the payment. For help and advice on this or any other VAT issue, please get in touch with your usual BDO contact or Richard Dalton or Wayne Neale.
HMRC’s new approach is set out in Revenue & Customs Brief 12 (2020).
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