HMRC rethinks new VAT policy for early termination and compensation payments

Although most early termination payments will still be subject to VAT, HMRC has now accepted that dilapidation payments made under leases where the property is not returned in the agreed condition at the end of a lease will normally be out of the scope of VAT.

Under the new policy, which applies from 1 April 2022, where supplies subject to VAT are made, other payments that are required to be made to the supplier under that contract, such as early termination fees, will usually also be subject to VAT. HMRC’s revised guidance states that in that situation the question will be “why isn’t other income [the supplier] has received in connection with that supply also within the scope of VAT?” 

Where a party agrees to do something in return for a fee, how that fee is described does not affect whether there is a supply for 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, HMRC’s guidance states.

Historically, HMRC took the view that payments described as “compensation” were typically outside the scope of VAT. Similarly, damages calculated according to provisions in a contract, such as liquidated damages were taken to be compensation for loss of earnings which was not subject to VAT. 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 ‘right to terminate’ which was subject to VAT.

On 2 September 2020, HMRC made a surprise announcement in Revenue & Customs Brief 12/2020 that as a result of European Union 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 that document, HMRC set out a new general rule that most such payments would now be subject to VAT instead of outside the scope of VAT as the guidance previously stated.

Brief 12/2020 said that taxpayers who had failed to account for VAT to HMRC on payments affected by the change in practice should "correct the error", unless they had a specific ruling from HMRC saying that such fees were outside the scope of VAT, when the new practice only had to be applied from 2 September 2020.

The guidance was criticised for its retrospective effect and the fact that it did not cover many common scenarios such as property transactions.

In January 2021, following representations from businesses and advisers, HMRC said it had decided to apply the updated VAT treatment from a future date and that it would be issuing revised guidance "shortly". In the meantime, HMRC said businesses could either apply the new practice and continue to treat payments as subject to VAT or go back to treating them as outside the scope of VAT in accordance with HMRC's former guidance.

“It is positive that HMRC revised its policy on the VAT treatment of compensation payments and early termination payments in the face of industry backlash over the attempt to make changes retrospective and in view of the multitude of issues upon which the original Brief was silent,” said Clara Boyd, a VAT disputes expert at Pinsent Masons. “Although it is regrettable that it has taken HMRC 17 months to restore certainty for businesses as to the VAT treatment of some very common payments.”

The revised guidance on dilapidation payments says that although there are arguments that these could represent additional consideration for the supply of the lease, HMRC’s policy is not to treat dilapidation payments as subject to VAT. However, the guidance says that HMRC might depart from that view if in individual cases it found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.

“The change of view on dilapidation payments is very welcome and reflects the true nature of these payments,” said corporate tax expert Eloise Walker of Pinsent Masons. “Property transactions were ignored in the September 2020 guidance but HMRC caused consternation in its discussions with the industry when it suggested that dilapidation payments should be subject to VAT.”

Penalties for late return of hired equipment, such as a car, is effectively an additional hire fee and will be subject to VAT, the guidance states.

However, if the customer were to write off the car and the supplier charges a fee for doing so the guidance states this will not be further consideration for the hire of the car. This is on the basis 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. 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, the guidance states that 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.

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 even if it is described as ‘damages’, according to the guidance.

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 will be outside the scope of VAT. 

If a lease or other agreement terminates early because the customer breaches the terms, then if the supplier charges a fee 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, then the payment is further consideration for the supply.

The guidance confirms that where a supplier breaches the terms of a contract, rather than the customer doing so, then they may reduce the price they charge for the supply, as what is being supplied has been altered. This will result in less VAT being charged if the supply is taxable. If the price is not adjusted, but the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered as a result of the breach, the guidance confirms that the payment will be outside the scope of VAT.

“The confirmation that payments made by the supplier should not be vatable is also welcome,” Walker said. “This type of payment is common under construction contracts, and it is reassuring to see the VAT treatment many will have adopted confirmed in the guidance. What will confuse the construction industry however is HMRC’s distinction between price adjustment and liquidated damages, where it is unclear what exactly they mean and where the new boundaries lie.”

“One thing that is certain following HMRC’s revised policy is that it will inevitably lead to more disputes with HMRC over whether or not a payment is directly linked to the supply,” Boyd said.

“The guidance to HMRC officers recognises that there will be cases that are not ‘clear cut’ and advises HMRC officers to ‘make a judgement as to whether the charge is sufficiently linked to the supply or not, weighing the factors and the economic reality’. In many cases, there will likely be a fine dividing line between a charge being outside the scope of VAT and falling to be taxed at the standard rate, with potentially significant financial consequences. As such, clear representations will need to be made to HMRC on those border-line cases, carefully considering all of the relevant factors,” she said.

All businesses must adopt the revised treatment no later than 1 April 2022. This includes any business that has had a specific ruling from HMRC saying that such fees are 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 may correct this on their next VAT return.