Drafting financial services contracts after changes to UK VAT for terminations

Out-Law Analysis | 29 Sep 2020 | 9:02 am | 3 min. read

Most early contract termination fees and payments made to settle commercial disputes could be within the scope of UK VAT, following a change in practice from HM Revenue & Customs (HMRC).

As a result, businesses need to revisit the VAT treatment of contract terminations. Financial services companies will be particularly concerned about ensuring the new treatment does not result in an increase in payments of irrecoverable VAT.

Previous HMRC guidance said that charges to withdraw from agreements to receive goods or services were not generally for a supply and were outside the scope of VAT. Similarly, damages calculated according to provisions in a contract, such as termination payments, were taken to be non-VATable compensation for loss of earnings.

In early September 2020 HMRC announced that it had withdrawn its previous guidance and had decided that, following recent EU judgments, these charges should normally be considered as being for the supply of goods or services, making them within the scope of VAT.

Although the EU cases relate to early termination of contracts, HMRC is applying the same principles to any payments made on the settlement of disputes relating to commercial contracts. It previously took the view that payments described as compensation were outside the scope of VAT unless the claim related to a payment that was withheld for VATable goods or services or the payment was for a future supply of VATable goods or services.

HMRC's new position is that where supplies under the contract are within the scope of VAT, the default position will be that payments received from the same customer will be supplies for VAT purposes. This may mean that compensation for loss of profit, or stranded or wasted costs will now be VATable.

Unhelpfully, HMRC's revised guidance does not specifically discuss the position in relation to contracts where the services supplied are VAT exempt. If compensation relates to a contract involving exempt supplies, in many cases the compensation should be treated as exempt from VAT.

With more compensation payments potentially within the scope of VAT, it may be that careful drafting of the initial contract can help to minimise the risk of an FS business suffering irrecoverable VAT.

Under HMRC’s previous practice, it was advantageous to include liquidated damages provisions around termination options in the contract as this could take any resulting payment outside the scope of VAT.

That no longer works, but in some situations there may still be advantages in separating out termination payments for different types of loss and cost – such as loss of profit, recovery of unamortised costs, wasted or stranded costs, and staff ramp down – and including a split by different services where some payments may be consideration for an exempt supply and some for a taxable supply. 

However, this break down of loss and costs will only be advisable where you do not want an all-encompassing composite supply to be taxable or exempt, as the case may be – this makes it a particularly complex area in relation to high value regulated BPO and investment platforms outsourcings where the VAT cost is potentially significant.

Any drafting for termination payments should also make it clear whether the amounts payable are stated inclusive or exclusive of VAT, so that if VAT is payable it can be applied appropriately. Importantly, any contract party who may have to pay termination payments will want to ensure it has a contractual right to a valid VAT invoice should the payment be subject to VAT.

Disturbingly, although HMRC has only recently announced its change in practice, it is suggesting that the VAT treatment of past payments needs to be revisited. It is not yet entirely clear whether HMRC will be looking as far back as the full four years permitted by law, given that the first EU judgment it is relying on was not given until November 2018 and HMRC has only just changed its published practice.

Looking at existing contracts to determine the ability to apportion VAT liability to one party or the other will be important – this is particularly the case for those where a VAT risk share is in place.

Businesses which have recently received significant payments as termination payments which were considered to be outside the scope of VAT, should take specialist advice at an early stage. Where a taxpayer has relied on HMRC guidance it may be that a legitimate expectation defence to any tax liability could be raised by way of judicial review, but the timescales for bringing such a claim are short.