Coronavirus: UK VAT traps when terminating or amending contracts

Since this article was published, HMRC has announced it has changed its view of the VAT treatment with retrospective effect. For more details see our Out-Law Guide: VAT on settlement of disputes and terminations of contracts.

Terminating a contract outside its terms

The coronavirus pandemic is likely to mean that some contracts cannot be performed or that there will be significant delays in performance. Many businesses will therefore look to exercise force majeure clauses, or to terminate contracts early in exchange for a termination payment, in order to escape contractual obligations.

As with all VAT questions, the crux of the issue is whether there has been a supply of goods or services which VAT is then chargeable upon. Where a contract is terminated early by a party and a termination payment is made, there can be a supply of 'a right to terminate', which may be subject to VAT.

Broadly, a right to terminate will have been supplied where the contract being terminated does not include that specific right to terminate early, and a separate agreement is concluded in respect of the termination in exchange for payment.

Therefore, generally the exercise of a termination right under a force majeure clause in and of itself is unlikely to attract VAT, as the right to terminate already exists in the original agreement and cannot be said to have been supplied at a later date. VAT can still arise out of the termination though, depending on what any payment is actually for.

By contrast, payments under a separate standalone termination agreement concluded at the time of termination are likely to attract VAT.

Recipients of such payments will want termination payments to be expressed as being VAT exclusive so that the payer funds the VAT element. The payer, especially if they are engaged in a VAT exempt business where input tax recovery is an issue, will want the payment to be VAT inclusive. A common pitfall to avoid is that contracts which are silent as to VAT are held to be VAT inclusive which means that the recipient finishes up with less money than anticipated if VAT has to be paid.

Paying compensation or other sums in settlement of claims

VAT law in respect of the payment of settlement sums in relation to disputes is not always clear.

As a result, VAT analysis in this area is based upon first principles; has there been, or will there  be, a supply of goods or services?

Damages or other compensation paid in relation to pure contractual breach are usually compensatory payments rather than consideration for a supply, and as a general rule recipients of such amounts should not have to account to HMRC for VAT in respect of them. In this regard, however, the terminology in the contract is irrelevant - just because a payment is labelled 'damages' or 'compensation' does not mean that it is such for VAT purposes.

There are also two principal exceptions to this general rule.

The first exception is where the claim relates to a payment that was withheld for VATable goods or services, perhaps because it is argued that goods are defective or services are not performed as agreed. The 'settlement payment' in respect of this type of claim is effectively part payment of the consideration for the original goods or services supplied and previously invoiced, and is therefore usually subject to VAT.

Secondly, 'compensation' payments are generally subject to VAT where the payment is for a future supply of goods or services which would be otherwise subject to VAT in any event. This scenario typically arises where the settlement payment is conditional upon, or the settlement agreement contains obligations in relation to, the supply of goods or services which, in the normal course of business, would fall within the VAT regime, such as continuing future use of appropriated IP rights, for example.

Settlement agreements should be drafted so that it is clear whether VAT is expected to be chargeable and who should bear the cost of any VAT.

A business seeking to terminate or sue on a contract should follow the following steps to protect its VAT position:

• consider the precise wording of the original agreement and of the termination agreement or settlement agreement.
• take early legal advice - determining whether VAT is payable on the sums demanded or settled is fact sensitive and depends upon whether any supply is being made.
• bear in mind their VAT recovery position and that of the other party. For example, financial services companies make mainly VAT exempt supplies and so will not want to incur any additional VAT charge they have not priced in to the settlement, as they are unlikely to be able to recover that VAT.
• in relation to termination of contracts, be aware that if termination is made outside any termination routes contained in the original contract, VAT will as a general rule probably be chargeable on any payment made to terminate the contract.