Revised HMRC policy on VAT treatment of early termination fees and compensation payments

Background

As covered in our previous article, HMRC announced in September 2020 that payments made to compensate a supplier arising out of early contract termination would in general be subject to VAT and no longer outside the scope of VAT (as had previously been the case). Following extensive representation to HMRC by businesses and their advisers, this policy was suspended in January 2021. A revised policy - Revenue and Customs Brief 2 (2022) - has now been published which should result in fewer payments being within the scope of VAT. Businesses must adopt the revised policy by 1 April 2022.

What termination payments are within the scope of VAT?

Under HMRC’s new policy, a payment to terminate a contract will be treated as further consideration for the contracted supply if the payment has a sufficient “direct link” to the supply. This requires a legal relationship where the supplier and recipient have reciprocal obligations of supply and payment (i.e. looked at from the supplier’s perspective, the fee received forms part of the actual value given in return for the supply). For example, it has been held that the retention of airline no-show fees had sufficient reciprocity with the airline’s transport obligations, concluding that the fees were further consideration for the passenger’s right to benefit from the airline’s performance of its obligations, and similarly amounts collected from defaulting gym members after they had been barred from using a gym were further consideration for a taxable supply of the right to use the gym facilities. The existence of a direct link will therefore be a question of fact and economic reality. This principle will apply regardless of whether the contract allowed for termination or a separate agreement is reached, and regardless of whether the payment is described as compensation or damages. The default provisions in a contract should not be expected to change the nature of what has been supplied in consideration of the payments the recipient has agreed to make. The main impact of the revised policy is that fees charged when customers terminate a contract early will be regarded as further consideration for the contracted supply in various scenarios, such as:

• fees charged to compensate a supplier for having made the supply available or for loss of earnings, in cases where the customer does not actually avail themselves of all or part of that supply and doesn’t pay the full amount agreed, e.g. cancellation fees, minimum commitment fees or tie-in fees (even if described as “damages”);
• early termination fees arising as a result of a customer breach, to cover the costs to the supplier of making the supply available;
• termination fees arising due to customer breach, which may exceed costs but are broadly equivalent to what would have been charged by the supplier had the contract not been terminated; and
• fees made in circumstances when there was no pre-existing right to terminate in the original contract.

Businesses will need to account for VAT on these fees if the contracted supply is taxable, at the same rate of VAT as applies to the supply.

HMRC examples include penalties charged for exiting a mobile phone contract early or for the late return of a hire car which in reality constitutes an additional fee for the hire, or parking fines which are effectively additional charges for use of a parking space.

When are termination payments not subject to VAT?

Dilapidation payments versus break fees

In welcome news for the real estate sector, HMRC has confirmed that dilapidation payments are normally outside the scope of VAT on the basis they should not be treated as further consideration for the supply of a lease, although HMRC might depart from that view in individual cases if there was evidence of value shifting from VATable rent to dilapidation payments to avoid accounting for VAT.

However, where a break clause is exercised to terminate a lease (whether or not provided for in the lease), the break fee will be subject to VAT in line with HMRC’s revised policy, unless exempt. This will depend on whether the option to tax has been exercised by the payee.

Other payments

Termination payments will fall outside the scope of VAT where there is no direct link between the payment and the contracted supply. According to HMRC, this can include:

• Payments that are made in respect of one-off events that are not expected as part of the contracted supply (even if contemplated as a possibility in the contract). For example, if a customer writes off a hired car, any fee charged by a supplier to cover this would not be treated as further consideration for the hire of the car. The writing off the car is clearly not normally expected as part of that supply so there is no reciprocity between the parties for that eventuality;
• Payments that are substantial and punitive in nature and clearly designed to deter a breach of contract rather than to compensate for loss of income (car parking fines can fall into this category);
• Breach of contract by the supplier (rather than the customer), where the supplier’s payment may operate as a price reduction with adjusted VAT as a result; and
• Breach of contract by the supplier where, absent an adjustment to the price, the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered or substantive costs for the customer which bear little relation to what was provided.

Liquidated damages

When made by a customer, these payments will require careful consideration. According to HMRC, they will be subject to VAT if, as a matter of economic reality, they form payments inside the scope of VAT under HMRC’s revised policy, such as fees paid to a supplier which equate to what would have been charged for the supply had it run as expected. HMRC notes, for example, vehicle finance leases that commonly require customers to pay liquidated damages on early hire termination to cover the loss of future rents will be taxable. However, where an amount due is clearly punitive and designed to prevent breach rather than to compensate for lost income, then the “direct link” between the payment and supply may be lacking and so outside scope.

Areas of Difficulty The areas of difficulty for our clients will be the “borderline cases” where the position is not clear cut, as in HMRC’s car hire and write-off examples. For example, fees paid pursuant to liquidated damages clauses in complex commercial contracts, the quantum of which may have been calculated to cover a combination of elements, including termination costs such as statutory redundancy, loss of profits, as well as to compensate beyond the supply period, or settlement fees involving mutual waivers or payments to benefit third parties. These types of cases may lead to difficult questions of analysis for both clients and HMRC officers and the need for apportionment and risk allocation in contracts and settlement arrangements. The likelihood is an increase in tribunal cases reflecting HMRC’s implementation of its new policy.

What to do now?

Businesses must adopt the revised policy by 1 April 2022, even if they have a prior ruling from HMRC saying that such fees are outside the scope of VAT. Businesses which relied on HMRC’s 2020 guidance to account for VAT on payments which, under the revised policy, are now outside the scope of VAT, can look to make an adjustment or claim to correct the VAT position under normal VAT error correction rules.

If you would like to discuss the implications of HMRC’s latest policy set out in this client alert, please do contact one of the people listed to the right.