Out-Law / Your Daily Need-To-Know

VAT on settlement of disputes and termination of contracts

Out-Law Guide | 15 Mar 2021 | 12:59 pm | 5 min. read

This guide discusses VAT issues that commonly arise on out of court settlements of commercial disputes and terminations of contracts. It does not discuss court settlements.

Editor's Note: In January 2021 HMRC announced that the 2 September 2020 change of practice would not be implemented until a future date and that HMRC will issue revised guidance in due course. Until then taxpayers can choose to apply either HMRC’s original practice or the 2 September change of practice.

When deciding the VAT treatment of a payment, it is necessary to start from first principles and it is important to always ask:

Where is the place of supply? If it is not the UK, UK VAT is not relevant. The usual rules apply here, so if, for example, a German car parts manufacturer is paying a settlement sum to a UK car brand for defective parts in cars sold in the US, the place of supply (if any) is Germany and it is German (not UK or US) VAT law which is in play

Is the supply made in the course of a business? For corporates in a commercial dispute, the answer is usually yes. But if, for example, a charity or individuals are involved, or the matter is personal to the parties, the answer may be different.

This guide assumes that the counterparties are both business entities and that the supply is made in the course of a business, with the place of supply being in the UK.

VAT: why it matters

Standard rated VAT in the UK is currently 20%. Establishing whether an extra 20% is due on a payment can affect the viability of the commercial decision underlying the amount of that payment for the payer.

This is particularly the case with businesses in VAT exempt sectors such as financial services, where VAT recoverability is limited or non-existent. Similarly, a payee will want to make sure it is obtaining that extra 20% where it has to account for VAT to HMRC in respect of the payment.

HMRC's position before 2 September 2020

Previous guidance from HM Revenue & Customs (HMRC), now withdrawn, said that when customers were charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT. Compensation for breach of contract was regarded as compensating for loss of profit rather than consideration for a supply (and therefore not VATable).

Similarly, damages calculated according to provisions in a contract, such as liquidated damages commonly found in construction contracts, were taken to be non-VATable compensation for loss of earnings.

On this basis, payments made relying on a force majeure clause, such as during the Covid-19 pandemic, would not have been regarded as VATable on the basis that there was no new supply of termination rights on which VAT could be charged.

If a termination payment was not made pursuant to the terms of the original contract, however, then the separate termination agreement concluded at the time of termination indicated that the payment was in exchange for a VATable ‘right to terminate’.

The main exceptions relevant to many commercial scenarios were where:

  • 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 position from 2 September 2020

On 2 September, HMRC announced in Revenue & Customs Brief 12/2020 that it now interprets two EU cases to set a new general rule that UK VAT is payable on early contract termination and cancellation fees, and HMRC extends this to compensation payments. The EU cases are MEO (C‑295/17) and Vodafone Portugal (C‑43/19).

HMRC’s new guidance in its VAT Supply and Consideration Manual at VATSC05910, VATSC05920 and VATSC05930.

Compensation payments

The basic position, therefore, has been reversed. The presumption should now be that most compensation payments are VAT-able unless an exception applies.

HMRC (at VATSC05910) anticipates exceptions ‘only where there is no direct link between a payment and a supply of goods or services’.

Liquidated damages clauses exist as a result of events envisaged under the contract. So, in HMRC’s view, they form further consideration for what is provided under it, as just another integral part of the price which the customer committed to paying.

Consequently, provided the compensation payment relates to a contract under which the payer had or will receive a VATable benefit in the first place, VAT will be payable. But a compensation payment relating to an exempt contract should presumably remain exempt from VAT.

In some cases contracts will require payments of liquidated damages to be made by the supplier and not by the customer. One example is in construction contracts where the contractor may have to make payments to the customer, where works are not finished by the specified date. The HMRC guidance does not deal with the situation where payments are made by the supplier. Although HMRC has not yet confirmed the position, payments made by the supplier will usually not be consideration for a supply and should therefore, depending on the circumstances, either be a repayment of some of the price paid by the customer, necessitating the issue of a VAT credit note, or be compensation which will remain out of the scope of VAT, notwithstanding HMRC’s change in practice.

Termination payments

Termination payments outside the original contract were already VATable, and previously, assessing VATability involved judging whether a new VATable ‘right to terminate’ had been supplied or not.

What is new is that all termination payments (whether set in the original contract or not) are now VATable (see HMRC’s revised guidance at VATSC05920).

What remains uncertain however is what happens when you terminate a contract making exempt supplies. If it is paid within the original contract, then logically per Meo and Vodafone Portugal it should be exempt – but the guidance is silent on this.


What happens if there are counter claims folded into the settlement? Unfortunately, VAT cannot be negated by setting-off payments against each other. If a settlement agreement explicitly caters for the settlement of a claim X and counterclaim Y where Y is VATable but X is not, you cannot deduct Y from X and say the sum is not VATable.

HMRC is clear (in VAT Notice 708, at para 22.3) that set-off does not eliminate a supply, even if it eliminates the payment in respect of that supply: there remains two supplies going in opposite directions, and you have to account for the VAT on amount Y.

However, wording a settlement agreement by stating a global figure paid in one direction comprises a settlement of all claims can avoid this issue (as there is then no set-off at all).

Multiple claims

HMRC's change of view makes the task of assessing the VATability of most compensatory and termination payments easier.

Under the previous position, a settlement made in respect of multiple claims, where some compensation was VATable and some was not could cause problems. It was best practice to clearly split out and spell out the VATable and non-VATable elements of the settlement sum, otherwise, there was a risk of HMRC seeing the whole payment as a single (most likely, VATable) composite supply.

Now issues from mixing VATable and non-VATable supplies within one payment will not often arise because there will simply be few non-VATable payments arising.

Settlement agreement drafting

For both parties (but particularly the payee), it is important to insert the words ‘plus VAT if applicable’ into the settlement agreement. This is because:

  • it encourages everyone to pause and consider the treatment, flushing out latent VAT issues; and
  • it ensures the commercial negotiators have brought the issue to the table and have not forgotten to raise it before they agree a sum.

Remember, a silent contract is a VAT inclusive contract, and it is too late for the payee to go back for that extra 20% once the agreement is signed.

This is especially true in scenarios where there is extra VAT compliance involved. For example, when the sum is a refund and triggers a credit note and unwind of excess input and output tax, everyone needs to be in agreement before the payer approaches HMRC for an output tax repayment.

Points to bear in mind

It is important to get the VAT treatment right in the settlement agreement itself, by answering these questions:

  • Do you expect VAT to be charged?
  • How will any proposed drafting impact VAT recoverability?
  • Who do you expect to bear the cost of any irrecoverable VAT?
  • Is there any compliance that the other side must undertake (e.g. issuing invoices or credit notes)?

Applying first principles and assessing the terms of the sued-upon contract as a starting point can usually address many of the potential issues outlined above.

This guide is based on an article by Eloise Walker and Dan Place of Pinsent Masons which appeared in Tax Journal on 31 July 2020; and a subsequent addendum to that article which was published online on www.taxjournal.com