Out-Law Analysis | 06 Oct 2020 | 2:28 pm | 8 min. read
The basis of the decision taken by HM Revenue & Customs (HMRC) to reverse its guidance on the VAT treatment of both early termination payments and other compensation payments relating to commercial contracts is questionable, and its move to apply the change retrospectively exceptionally harsh in the current economic climate.
On 2 September, HMRC made a surprise announcement in Revenue & Customs Brief 12/2020 that as a result of Court of Justice of the European Union (CJEU) case law, it was changing its published guidance on the VAT treatment of both early termination payments and other compensation payments relating to commercial contracts. In brief, HMRC has set a new general rule: most such payments will now be subject to VAT instead of outside the scope as the guidance previously stated.
HMRC is basing its change in practice on two CJEU decisions both relating to payments made to telecom companies in respect of the early termination of customer contracts
Partner, Head of Corporate Tax
HMRC’s volte-face here has at best a dubious basis in EU law
In a case involving Portuguese telecoms provider MEO, contracts provided that if terminated before the end of the minimum fixed term, MEO was entitled to compensation equal to the full remaining payments for the fixed term period, even if the customer no longer received services from MEO.
The CJEU said that as MEO got paid the same regardless, early termination did not alter the economic reality of the relationship between MEO and customer. The customer had a right to MEO’s services, even if the customer did not wish to avail themselves of it. This meant that the ‘compensation payment’ should be treated as consideration for a supply of the services and therefore VATable.
In another telecoms case involving Vodafone Portugal, customers terminating contracts early had to pay an amount calculated under Portuguese law to reimburse Vodafone. This was not the same as the amount they would have had to pay had the contract continued. The CJEU said that the amount payable on early termination was an integral part of the price which the customer committed to pay. So, in economic reality, the early termination fee sought to guarantee Vodafone a minimum contractual remuneration for the service provided and was therefore VATable. The CJEU said it was irrelevant that the contract did not give Vodafone the same income as it would get if the customer had not terminated early.
In Revenue & Customs Brief 12/2020, HMRC said that, following the rulings in the cases of MEO and Vodafone Portugal, "it is evident" that when customers pay to withdraw from agreements to receive goods or services these charges are normally considered as being for the supply of the contracted goods or services. On this basis, HMRC said that most early termination and cancellation fees are therefore liable for VAT, even if they are described as compensation or liquidated damages. The VAT Supply and Consideration Manual confirms that payments arising out of early contract termination will be treated as consideration for a taxable supply in cases where the original contract allows for such a termination, as well as when a separate agreement is reached.
HMRC’s guidance further provides that although liquidated damages payments are designed to compensate, they result from events envisaged under the contract and are therefore consideration for what is provided under it.
In a wider context, any payment to settle disputes relating to commercial contracts now appears VATable. HMRC said that "payments that might or might not be compensation do not arise in a vacuum" and that if the regular supply is VATable, this other income must be as well, unless there really is no direct link between payment and supply.
The recent cases were each decided on their own facts. The MEO case was already set as an exception to the old general rule, but that was on the basis that, on a proper construction of that particular contract, the label ‘compensation’ did not reflect reality – because the customer was paying the full contract price whether they used the service or not, the ‘compensation’ was not compensation but payment for services rendered and therefore VATable. The judgment in the Vodafone Portugal case took this a step further: Vodafone did not get the same amount it would have received had the contract continued – Portuguese law prohibited that – but the termination payment was still additional consideration for the supply of services given the position between the parties and the terms of the contract.
One can see why HMRC might feel obliged to take the small step from there to treat Vodafone Portugal as not another outlier decided on its own facts but instead say that all in-contract termination payments are VATable. It is also an easy tax grab – especially against the telecoms industry which has a host of individual consumers with no VAT recovery – and one for which the CJEU can easily be blamed.
However, it is a mighty leap to then say that all compensation payments, be they liquidated damages or in another form, must then be VATable. That is not what the CJEU said in either of its rulings. So HMRC’s volte-face here has at best a dubious basis in EU law.
The new guidance is sadly not as well thought through or clear as it should be for such a sweeping and unheralded change. The guidance states: "HMRC’s policy is to treat payments arising out of early contract termination as consideration for a taxable supply". Except, they are not. If you apply the CJEU's ruling in the Vodafone Portugal case, the payment for in-contract termination is VATable because it is further consideration for the original supply. However, what if your underlying supply is exempt? It is arguable that the termination payment must be exempt as well in such cases.
The uncertainty will be particularly acute in relation to property transactions. Payments under break clauses in leases are caught by the new guidance so that where a payment is made in accordance with the terms of the lease, there will now be a supply for VAT purposes. One would expect this supply to follow the VAT treatment of the lease – to be taxable for a commercial property where there has been an option to tax, but exempt if no option has been made. However, HMRC’s guidance is silent on this and, if you did not know the details of the cases, might imply that termination payments will always be VATable, period. We will have to hope that they amend their new guidance to make this clear.
HMRC really does seem to be suggesting that this change is retrospective. In a departure from its usual practice, the change appears to have effect not just from the date of the announcement, but, unless you happen to have obtained a formal written ruling on the point, for past periods too.
Partner, Head of Corporate Tax
HMRC could not have chosen a worse time to announce a retrospective change in practice, given that the coronavirus pandemic has resulted in very many more contract terminations than usual, and litigation settling that might otherwise go to court
There are implications for those who have already made payments in reliance on HMRC’s now withdrawn guidance.
Before 2 September 2020, HMRC’s manuals stated that charges to withdraw from agreements to receive goods or services were not generally for a supply and were outside the scope of VAT. A settlement payment to terminate obligations under a contract made, under the terms of the contract, for example, relying on a force majeure clause, would not usually have been VATable. Similarly, subject to some exceptions where there was clearly a VATable supply in play, such as payment for unpaid invoices or future access to further services, damages or other compensation paid in relation to pure contractual breach were usually compensatory payments outside the scope of VAT rather than consideration for a supply.
Consequently, parties terminating contracts early will have paid the contractual compensation without applying VAT, because it did not apply. Similarly, parties settling commercial disputes – unless the dispute fell within one of the established exceptions to the old general rule like unpaid invoices or scope of future services to be delivered – will have assumed the payment was not VATable. Indeed, had the payee tried to charge VAT, the payor would have found themselves unable to get input VAT credit from HMRC as purported VAT is not refundable VAT, and the payee might then struggle to get back a refund of this ‘non-VAT’ from HMRC if HMRC chose to apply their much abused ‘unjust enrichment’ defence.
The guidance now states that such compensation payments will be VATable. VATSC05910 states that "it is only where there is no direct link between a payment and a supply of goods or services that it may be outside the scope of VAT", citing the case of Mohr v Finanzamt Bad Segeberg where payments were made by state authorities to farmers to cease milk production, and were not VATable because the authorities received no benefit for the payment so the payment cannot have been linked to any supply for VAT purposes. Since it is difficult to conceive of commercial situations where this exclusion to VAT could be applied, for all practical purposes pretty much all compensation payments should be presumed VATable.
Brief 12/2020 casually says that taxpayers who have failed to account for VAT to HMRC on payments affected by the change in practice should "correct the error". It is only those with a specific ruling from HMRC saying that such fees are outside the scope of VAT that are required to account for VAT on payments received after 2 September.
There is no indication on how far back taxpayers need to be looking to correct such errors’. Should we go back for the last four open periods? Two years, to account for the MEO judgment was given in November 2018? Or a few months, given the Vodafone Portugal CJEU judgment came out in June 2020?
It would be unreasonable for HMRC to have expected taxpayers to have been accounting for VAT on this type of payment for years when they did not know they should be until the CJEU's decision in the Vodafone Portugal case. However, the market rumour, from several independent sources, is that HMRC is looking at prior open periods.
And do not think a previous chat with your friendly customer compliance manager (CCM) will get you out of it. If you do not have a formal written application to and response from HMRC on the matter, assuming you could have predicted the sweeping extent of the change in advance and got such a ruling in the first place, apparently you can forget it. One can only hope HMRC has a late change of heart. Otherwise, so much for cooperative compliance.
HMRC could not have chosen a worse time to announce a retrospective change in practice, given that the coronavirus pandemic has resulted in very many more contract terminations than usual, and litigation settling that might otherwise go to court. It also seems incredibly harsh for HMRC to claim that taxpayers must apply a CJEU decision before they even knew what it was, and especially when HMRC has changed its guidance to encompass situations beyond the CJEU decisions’ apparent ambit.
In suggesting that taxpayers need to correct prior returns, HMRC has either not considered or chosen to ignore the practicalities of doing so. Once a settlement payment has been made it is seldom possible to ask for an extra 20% later – even if you have a VAT clause that lets you do so. So HMRC is just taking a cut from the original payment, and the payee keeps less compensation than they expected. This is particularly problematic at present when the coronavirus pandemic has prompted more terminations and settlements and some sectors, such as hotels and hospitality, are fighting for survival.
If HMRC maintains its stance that past ‘errors’ require correction, it can expect arguments that taxpayers have a ‘legitimate expectation’ that HMRC will apply its published guidance until it changes. How much money will this raise, and will the damage to business confidence in cooperative compliance be worth it? Hopefully HMRC will consider that question, and then quietly bin the retrospective elements of the change.
This is based on an article by Eloise Walker which appeared in Tax Journal on 23 September 2020.