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HMRC’s change of policy on compensation and contract termination payments

HMRC announced last month that compensation or early contract terminations, including liquidated damages, should be subject to VAT at the standard rate – and that this change has a retrospective effect on past periods too.

Last updated: 15 October 2020

HMRC's previous guidance was that when customers were charged to withdraw from agreements to receive goods or services, these charges (including liquidated damages) were not generally for a supply, and were therefore outside the scope of VAT. Only where a separate agreement was needed to allow for the right to terminate, were payments subject to VAT.  

But in Revenue & Customs Brief 12/2020, HMRC announced that in the light of recent European VAT cases, their revised view is that charges for compensation or early contract terminations, including liquidated damages, should be treated as consideration for a supply, and therefore most payments are subject to VAT at the standard rate. 

If as a result of the COVID-19 pandemic you’re looking to terminate contracts due to your organisation’s changing requirements, for example cleaning, security, temporary workers etc., and your organisation cannot deduct VAT on costs, you’ll need to factor the VAT treatment of any termination payment into your considerations. 

About the authors

Linda Skilbeck

+44 (0)20 8037 3114
skilbeckl@buzzacott.co.uk
LinkedIn

Thomas Mobee

+44 (0)20 7556 1320
mobeet@buzzacott.co.uk
LinkedIn

Last updated: 15 October 2020

HMRC's previous guidance was that when customers were charged to withdraw from agreements to receive goods or services, these charges (including liquidated damages) were not generally for a supply, and were therefore outside the scope of VAT. Only where a separate agreement was needed to allow for the right to terminate, were payments subject to VAT.  

But in Revenue & Customs Brief 12/2020, HMRC announced that in the light of recent European VAT cases, their revised view is that charges for compensation or early contract terminations, including liquidated damages, should be treated as consideration for a supply, and therefore most payments are subject to VAT at the standard rate. 

If as a result of the COVID-19 pandemic you’re looking to terminate contracts due to your organisation’s changing requirements, for example cleaning, security, temporary workers etc., and your organisation cannot deduct VAT on costs, you’ll need to factor the VAT treatment of any termination payment into your considerations. 

Retrospective impact

Retrospective impact

In a controversial departure from usual practice, RCB 12/2020 states that ‘Any taxable person that has failed to account for VAT to HMRC on such fees should correct the error’. HMRC’s reference to ‘errors’ seems unjustified when their previous guidance referred to most compensation payments, and particularly liquidated damages, as outside the scope of VAT.

If confirmed, the change of policy has effect not just on payments from the date of the announcement, but (unless you’ve obtained a formal written ruling on the point) also on past payments. There’s no indication in the brief on how far back you need to look to correct such ‘errors’. This is normally a four year period, but the cases that caused HMRC to publish this brief date from 2018 and 2020, so this could be up to a two-year period. 

HMRC's new guidance

HMRC’s new guidance 

HMRC’s new guidance has also come in for much criticism from professional advisers. It refers only to taxable payments, but if the underlying supply was exempt or zero-rated there’s a good case to argue no VAT would be due. If a tenant was looking to terminate a lease, the VAT due would depend on whether the landlord had 'opted to tax' the property for VAT purposes. If an option had been made the payments would be subject to VAT; otherwise, payments ought to be exempt. Unfortunately the guidance is not clear on this.

In addition, there is some doubt as to whether the principles in the cases to which HMRC refer, which concerned mobile phone contracts, actually apply across the board to all compensation payments. 

These points have been raised with HMRC and we understand that they have instructed officers not to act on the new guidance until such concerns have been addressed. We will update this article when we have more information. 

What should you do?

What should you do? 

At present we understand there will be no immediate action necessary until HMRC respond to the points. If you’ve paid early termination payments to a supplier, if the new policy is confirmed and the contract was silent on VAT, the supplier is unlikely to be able to retrospectively charge you additional VAT unless you agree (you could do this if you are able to claim the VAT from HMRC). We suggest reviewing any recently terminated contracts, to establish whether you may be liable.

If you’ve received a termination payment from a customer/tenant prior to the announcement, and if the new policy is confirmed, you may need to account for VAT by disclosing the amount due to HMRC in order to avoid potential penalties. Unfortunately once you’ve received a settlement payment from a customer, it’s rarely possible to ask for an extra 20% later on – even if there is a VAT clause in the contract. The new policy would mean in that case you would retain less compensation than expected, unless you’re able to recoup the VAT from the customers who may be willing to accept a VAT charge if it represents no net cost to them.  

Get in touch
Get in touch 

Whether you’re the supplier or the customer, there are key considerations to make regarding previously terminated contracts and planning for the future. For more information on the above, and for advice tailored to you, please fill out the form below and one of our VAT specialists will be in touch.  

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