HMRC updates VAT guidance on early termination fees and compensation payments

Revenue & Customs Brief 2 (2022), which was published on 7 February 2022 alongside updated guidance in HMRC's VAT Supply and Consideration Manual (see VATSC05910, VATSC05920 and VATSC05930), introduces a revised VAT policy on early termination payments and compensation payments. 

The Brief replaces Revenue & Customs Brief 12 (2020) which had originally brought many early termination fees and compensation payments into the scope of VAT (see our previous Insight) but was subsequently suspended in January 2021 with HMRC stating that its new policy would be applied from a "future date" (for more details see our Insight). 

The revised guidance has provided some welcome clarity over the treatment of certain payments that are made in the real estate and construction sectors, including payments that will be treated as outside the scope of VAT. Businesses must adopt the revised treatment no later than 1 April 2022. Where the revised guidance results in the need to recognise a supply, this must be followed by businesses even if they have 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 guidance published in 2020 and accounted for VAT on transactions, which under the revised guidance are outside the scope of VAT, may correct this in the normal way (commonly by making an adjustment in the businesses' next VAT return).

Direct link 

The revised guidance confirms that, if there is a direct link between what is done and the payment received, and there is reciprocity between the supplier and the customer (that is, the supplier agrees to provide a service which the customer benefits from), then the payment is consideration for a supply for VAT purposes. This will be the case even if the payment is described as compensation or damages.

Liquidated damages

In general terms, HMRC will treat payments by customers arising out of early contract termination as further consideration for the contracted supply where the payments are linked to that supply. This will apply in cases where the original contract allows for such a termination, as well as when a separate agreement is reached. This approach is consistent with the decisions in the Court of Justice of the EU cases of MEO and Vodafone Portugal.

The revised guidance now also addresses liquidated damages paid by suppliers and will be important in the context of construction contracts. It provides that where a supplier breaches the terms of a contract and the price itself is reduced down then, if the adjustment is made retrospectively, the supplier must adjust the VAT they have accounted for to reflect the reduced price. The revised guidance comments that if the customer is asked to pay less it is likely that, in economic reality, the price has been reduced to reflect the lower value of what was actually provided. 

The revised guidance, however, also provides that 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 payment will be outside the scope of VAT. The guidance comments that this would be where the breach may result in substantive costs to the customer for which they seek recompense and where such payment may bear little relation to what was provided. Where this is the case, the payment will not be sufficiently linked to the supply to be treated as reduced consideration for VAT purposes.  

Accordingly, in the context of construction contracts, it will be important in practice to be clear as to the contract terms through which any breach by a contractor is dealt with and whether it is through the operation of a payless notice which may contractually operate as a reduction in price (in which case the contractor will adjust the VAT accordingly) or a payment of agreed damages (which should be outside the scope of VAT). 

Break fees

The revised guidance highlights that where a lease, or other agreement, ends as a result of an action by the customer that causes the supplier to terminate the lease, 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. 

Consequently, as we highlighted in our previous Insight, where a break clause is exercised to terminate a lease, there will now be a supply for VAT purposes, which will be exempt (unless the option to tax has been exercised by the party receiving the payment) regardless of whether the break fee amount is provided for in the lease.

Payments for dilapidations

There was some concern, following the 2020 Brief, that dilapidations may also be brought within the scope of VAT. Thankfully, following engagement with industry on this point, the revised guidance confirms that although dilapidation payments can vary in the way they are provided for, HMRC will generally continue to treat these as outside the scope of VAT (representing a claim for damages by the landlord against the tenant’s "want of repair" rather than consideration for a supply for VAT purposes).  However, HMRC highlights that it may "depart from that view if in individual cases we found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT".

OC comment

After more than a year of waiting for confirmation of the date when HMRC would apply its revised guidance, the new brief is welcome and provides needed certainty for businesses operating in the real estate and construction sectors. It is also encouraging that HMRC has listened to views from industry bodies and the revised guidance addresses the concerns coming out of the 2020 guidance. Real estate practitioners, in particular, will breathe a sigh of relief that, generally speaking, the current VAT treatment of dilapidation payments as set out in VAT Notice 742 Land and Property has been preserved.