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Last updated: 9 Mar 2021
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The latest on HMRC’s policy on compensation, termination payments and dilapidations

Since HMRC’s announcement in September 2020 that payments for early contract termination, liquidated damages and dilapidation payments should be retrospectively subject to VAT, they are reconsidering their position. Further guidance is not expected for some time. 

Genuine compensation is not consideration for a supply, and is outside the scope of VAT. But this description is often misleading, and many payments described as compensation, damages, or even as a fine, are actually in the nature of payment for goods and services, so that a supply needs to be recognised and, if it is a taxable supply, VAT needs to be accounted for. Up to September 2020, HMRC's  guidance on termination payments was that when customers were charged to withdraw from agreements to receive goods or services, these charges (including liquidated damages) were not generally payment 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 due to recent European VAT cases, their revised view was 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 and they changed the guidance in their manuals. 

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

Genuine compensation is not consideration for a supply, and is outside the scope of VAT. But this description is often misleading, and many payments described as compensation, damages, or even as a fine, are actually in the nature of payment for goods and services, so that a supply needs to be recognised and, if it is a taxable supply, VAT needs to be accounted for. Up to September 2020, HMRC's  guidance on termination payments was that when customers were charged to withdraw from agreements to receive goods or services, these charges (including liquidated damages) were not generally payment 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 due to recent European VAT cases, their revised view was 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 and they changed the guidance in their manuals. 

Retrospective impact

Retrospective impact

In a controversial departure from usual practice, RCB 12/2020 stated that the change would require any taxable person that had failed to account for VAT on such fees to ‘correct the error’. The change of policy thus had effect not just on payments from the date of the announcement, but (unless you’d obtained a formal written ruling on the point) also on past payments, subject to the four year capping provisions.

HMRC's new guidance

Revenue and Customs Brief 12/2020 to be withdrawn

HMRC’s revised guidance received much criticism from professional advisers and it appeared HMRC had not considered the full implications. There was considerable doubt as to whether the principles in the cases to which HMRC referred, which concerned mobile phone contracts, actually applied across the board to all compensation payments. After discussions with trade and other bodies, in October 2020 HMRC indicated that they were reviewing the matter, and that their staff had been asked for the time being not to take any action based on the RCB. In December 2020 they confirmed that the RCB would be withdrawn, that the new policy would apply only from 1 February 2021 and that new guidance would be issued. 

Dilapidations payments

Most commercial leases provide for a landlord to recover a dilapidations payment from a tenant on or nearing the end of the lease. Until the September 2020 change of practice, dilapidations payments were generally accepted as outside the scope of VAT, as they were seen as purely compensation (a claim for damages by the landlord against the tenant’s "want of repair") and not consideration for a supply of goods or services and HMRC Notice 742 still states exactly that.

But when HMRC announced the review of the guidance in December 2020 they indicated it was likely to state that dilapidations payments are subject to VAT if the landlord has opted to tax, on the grounds that they represent a fee which the tenant has to pay to the landlord if the tenant has not kept the property in the appropriate state of repair as required by the lease. In other words, in HMRC’s view, dilapidation payments are additional consideration payable by the tenant under the lease.

But this is not how dilapidations actually work in practice, as they are damages for breach of a repairing obligation in a lease, rather than simply a fee payable to the landlord, and all the representative bodies made this point to HMRC. 

What should you do?

What should you do?

On 25 January 2021 HMRC issued a statement which said “HMRC has decided to apply the updated VAT treatment set out in the brief from a future date. We will issue revised guidance, and a new Revenue and Customs brief to explain what businesses need to do shortly. This will include guidance on what to do if they have already changed how they treat such payments because of this brief. Until that guidance is issued businesses can either:

• continue to treat such payments as further consideration for the contracted supply

• go back to treating them as outside the scope of VAT, if that is how they treated them before this brief was issued.”

We now understand that HMRC are considering whether there is scope to amend the position set out in RCB 12/20, which will take several weeks, and only after that will revised guidance be available.

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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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