Updated guidance on the VAT treatment of early termination fees and compensation payments will impact on any business involved in a dispute
HMRC, following the publication of Revenue & Customs Brief 12/2020, now considers, in most cases, that early termination or cancellation payments will be treated as subject to VAT. This applies even if the amounts are described by the parties as compensation or damages, and regardless of whether the original contract allowed for early termination or a separate agreement was reached in respect of such termination.
HMRC's update provides greater clarity in an area that can sometimes be a last-minute sticking point in commercial settlement discussions.
What was the position before?
HMRC previously considered that payments described as compensation were typically outside the scope of VAT. Reconciling conflicting tribunal decisions in this area, HMRC drew a distinction between instances where the contract originally contained a right to terminate early in lieu of compensation for losses arising from the termination (where HMRC considered there was no supply for VAT purposes) and cases where a separate agreement was required to enable termination (this was viewed as a supply for VAT purposes).
HMRC's current view
Drawing on recent Court of Justice of the EU case law (Meo (C-295/17) and Vodafone Portugal (C-43/19)), HMRC now consider that – irrespective of whether the original contract contained a right to early termination and of how the payments are described – amounts paid in respect of early contract termination are consideration for a taxable supply. The rationale is broadly that the amount payable on early termination should be construed as part of the price which the customer had committed to pay under the contract.
VAT and settlement negotiations
A payment for early termination will sometimes form part of an agreed settlement in a contractual dispute. If both parties are VAT registered and fully taxable, then the VAT treatment is typically less of a concern for them – the paying party can recover the VAT as input tax. However, if the paying party (typically the defendant) is not VAT registered or is partially exempt, charging VAT will be a real cost to the settlement, potentially throwing a spanner into the works, and so needs to be thought about at an early stage and any ambiguity covered in the settlement agreement. Furthermore, while HMRC’s updated guidance focusses on early termination, there are other areas that need careful attention. Payments in respect of other elements of the claim, such as for breach of specific terms, may have a different VAT treatment depending whether they can be characterised as a payment for goods and services, or whether it is an outside the scope payment of damages. If so, some form of apportionment may be necessary, and this too could prove contentious. Depending on the location and nature of the parties and any services supplied, the place of supply rules could further complicate matters.
Nevertheless, the new guidance should narrow the scope for arguments over the VAT treatment to some extent – the presumption now will be that any early termination payments are subject to VAT.
On a less positive note, HMRC is insisting that, despite the wording of its earlier guidance, any taxable person who has not accounted for VAT on early termination payments should notify and correct the error with HMRC (subject to the usual rules and time limits around VAT error correction). Taxpayers, who are concerned that they may be affected, should take prompt action to mitigate possible penalties and explore whether the terms of the settlement allow any unpaid VAT to be recovered from the paying party.