Out-Law Guide 8 min. read
01 Dec 2023, 4:40 pm
After a period of uncertainty, in February 2022 HM Revenue & Customs (HMRC) published its revised policy on the UK VAT treatment of payments made on termination of contracts and litigation settlement agreements.
Historically, payments made under a contract and described as ‘compensation’ or ‘damages’, including on termination, were typically considered by HMRC to be outside the scope of VAT. Similarly, damages calculated according to provisions in a contract, such as liquidated damages were deemed to be compensation for loss of earnings and therefore, not subject to VAT. There were exceptions to this position; for example, if a termination payment was made under a separate termination agreement concluded at the time of termination the payment was construed as being in exchange for a ‘right to terminate’ and, therefore, was subject to VAT. VAT may also have been payable on termination payments for unpaid invoices or for future VATable supplies.
The position had been in flux since September 2020, when HMRC made a surprise announcement that it was changing the VAT treatment of early termination payments and other compensation payments made under commercial contracts.
On 2 September 2020, HMRC published Revenue & Customs Brief 12/20, in which it announced significant changes to the VAT treatment of termination payments under commercial contracts. A new general rule was introduced whereby "most early termination and cancellation fees would be liable to VAT". The brief explained that changes were being introduced in response to two recent judgments of the Court of Justice of the European Union (CJEU) involving telecommunications providers Meo and Vodafone Portugal.
HMRC's rationale was that, ordinarily, the circumstances where compensation arises and becomes due are a direct result of events envisioned by the parties when entering the contract and, therefore, are further consideration for the original supply of goods and services.
Given the prevailing uncertainties surrounding the distinction between price adjustments and liquidated damages and whether a termination payment is directly linked to a supply, future disputes between businesses and HMRC are envisaged
Notwithstanding that the new rules were stated to apply to payments from 2 September 2020, HMRC's guidance was heavily criticised for having a retrospective effect and requiring taxpayers who had relied on HMRC's previous position on VAT to ‘correct’ errors and account for unpaid VAT unless they had a specific ruling from HMRC confirming that fees were outside the scope of VAT. The guidance failed to confirm the VAT position in relation to dilapidation payments, and therefore also created significant uncertainty in the property industry.
In January 2021, following intense lobbying from businesses and advisers, HMRC partially retracted Brief 12/20, announcing that it would apply the updated VAT treatment outlined in Brief 12/20 from a future date and would "shortly" issue revised guidance. Until the new guidance was issued businesses could either continue to treat relevant payments as further consideration for the contracted supply or revert to treating them as outside the scope of VAT, in accordance with HMRC's former guidance.
The announcement was welcomed across industries, particularly the news that any revised policy would not take retrospective effect. In the midst of the Covid-19 pandemic, large numbers of contracts had been terminated prematurely. Confirmation that termination payments would remain outside the scope of VAT was therefore met with relief.
Revenue and Customs Brief 2/22, replacing Brief 12/20, confirmed that intra-contract termination payments and payments under settlement agreements should follow the VAT treatment of the underlying contract. Broadly, therefore, compensation payments to suppliers are liable for VAT if the goods and services for which fees were paid under the underlying contract were liable for VAT. This position applies regardless of whether such payments are described as damages or compensation. In keeping with the CJEU’s decisions in the Meo and Vodafone Portugal cases, the rationale is that these payments are considered further consideration for the contracted supply.
HMRC confirmed that when determining whether a termination payment is subject to VAT, what matters is whether something is done and if there is a direct link between what is done and the payment received, and reciprocity between the supplier and the customer.
If there is a material breach of a lease or agreement by a customer resulting in early termination, any fee charged by the supplier to cover the costs of making the supply, or an additional fee broadly equivalent to what would have been charged under the contract had it run as envisaged is deemed to be further consideration for the supply and, therefore, subject to the same VAT treatment as the underlying contract.
From 1 April 2022, the VAT treatment of termination payments falls into two categories:
Despite payments being described as ‘damages’, the guidance confirmed that where a supplier makes a supply available to a customer, but the customer does not avail themselves of all or part of that supply, and the supplier charges a payment to compensate them for having made the supply available, that will normally be further consideration for that supply and, therefore, subject to VAT. However, if the customer is charged a fee at a level that is clearly punitive and is designed to prevent breach rather than to compensate for lost income, then it could still be outside the scope of VAT.
Conversely, it is expected that compensation payments from suppliers to customers should be treated as refunds of VATable consideration and, therefore, a refund of VAT may be due. For example, a supplier may reduce the price of a supply following a breach of contract on its part. The reduction is being made because the supply has effectively been altered by the supplier's breach. Where the supply is subject to VAT, the reduction will result in less VAT being charged and, therefore, a refund may become payable. Where there is no price adjustment and the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered by virtue of the breach, the payment is more likely to remain outside the scope of VAT.
This development has been welcomed, particularly across the construction sector where compensation payments of this nature are common. However, HMRC's distinction between when a payment is a price adjustment rather than liquidated damages is unclear and therefore, uncertainty remains as to when a payment is a refund rather than pure compensation.
The September 2020 brief had been silent on the issue of VAT on dilapidation payments, made by a tenant to a landlord if buildings are not returned in the agreed condition at the end of a lease. Prior to publication of Brief 2/22, there had been increasing consternation across the property industry that VAT may be payable. In Brief 2/22, HMRC accepted that dilapidation payments made under leases will normally be outside the scope of VAT, since they are not further consideration for the supply of a lease. This was seen as a welcome development, reflecting the true nature of these payments.
However, HMRC acknowledges that arguments exist that dilapidation payments could represent additional consideration for the supply of the lease. Indeed, HMRC explains that it might depart from its view on dilapidation payments if there is evidence of value shifting from rent to dilapidation payments to deliberately avoid VAT. It is expected, however, that such a departure will occur only in egregious cases of attempted avoidance.
Brief 2/22 confirms that penalties for late return of hired equipment, such as a car, will be subject to VAT since the penalty is considered to be an additional hire fee linked to the original supply.
However, if a customer writes off a car, any fee charged by the supplier would not be subject to VAT. The rationale here is that the supplier does not agree that the customer can write the car off, and this is not something one would normally expect as part of the supply of a hire car. Although the contract may envisage the possibility that the car will be written off and provide for a fee to be paid should that eventuality arise, this is not further consideration for the supply as the necessary reciprocity does not exist.
Additional car parking fees for overstaying will be subject to VAT if the fee is for the additional use of the parking space. However, where a fine is substantial and punitive and is designed to deter a breach of the terms and conditions of parking, it will be outside the scope of VAT.
The new rules require businesses to consider the VAT position regarding most compensation payments and litigation settlements since they are likely to be considered further payments or repayments for the underlying supply under the contract and, therefore, subject to the VAT regime instead of being outside the scope as previously.
However, Brief 2/22 confirms that VAT is not automatically payable on compensation payments. Taxpayers must follow the VAT treatment of the underlying contract, therefore, compensation on an exempt contract should also be exempt. On this basis, it is important to ensure that settlement agreements proscribe whether future compensation sums are inclusive or exclusive of VAT – a silent agreement deems payment made under it to be inclusive of VAT.
When paying compensation in relation to a contract, the VAT treatment should usually follow the VAT treatment of the underlying contract. If the underlying goods/services are VATable, the compensation will also be VATable. Therefore, when negotiating a settlement, a business will need to ensure that VAT is applied correctly – i.e. no VAT if the underlying contract is VAT exempt.
Generally, when receiving compensation, the sum should not be subject to VAT, since the payment is travelling in the ‘wrong’ direction to be considered further consideration for a supply. It remains the case that the settlement of litigation is not itself a supply – there is no supply of giving up your right to sue.
When expecting a payment, whether in relation to a compensation claim under a contract or for remedial works or other damages, a business will need to ensure that VAT is charged, and an invoice delivered where appropriate.
All businesses must have adopted the revised treatment no later than 1 April 2022, regardless of whether they had previously received a ruling from HMRC that a termination fee would be outside the scope of VAT. Any business that adopted the treatment outlined in the September 2020 guidance and accounted for VAT on transactions which under the revised guidance are outside the scope of VAT should have corrected this on their next VAT return.
HMRC's Brief 2/22 has provided welcome clarity for business that was well overdue. However, given the prevailing uncertainties surrounding the distinction between price adjustments and liquidated damages and whether a termination payment is directly linked to a supply, future disputes between businesses and HMRC are envisaged.
Co-written by Dan Place, a corporate tax expert at Pinsent Masons. This guide is based on an article which was first published on Lexology.