After a long wait, HMRC has finalised its guidance on the VAT treatment of contract termination payments in R&C Brief 2 (2022). The revised policy takes effect from 1 April 2022.
Prior to September 2020, HMRC’s policy was relatively straightforward and well-understood. Broadly, any contract termination payment provided for in the contract would be outside the scope of VAT, whereas anything separately agreed after the fact would generally be subject to VAT as consideration for the granting of a right to terminate.
The successive CJEU decisions in MEO (in 2018) and Vodafone (in 2020) cast doubt on that policy. As a result, HMRC announced a significant policy change in September 2020 with the issue of R&C Brief 12 (2020) which suggested that almost all such payments were subject to VAT. That policy change was generally criticised as going beyond MEO and Vodafone, and the latest guidance has narrowed the scope of the change.
Summary of the revised guidance
- Where a customer terminates a contract early and makes a payment to the supplier to compensate for costs incurred to enable the supplier to fulfil the contract, or the customer is simply obliged to pay the full contract price regardless of the early termination, that payment will be further consideration for the underlying supply and subject to VAT where that supply is subject to VAT.
- Where the customer uses goods or services to a greater extent than envisaged in the contract, and pays an amount to the supplier to compensate them for that additional use, that will be subject to VAT if the underlying supply is subject to VAT. The example given by HMRC is a customer who returns a hire car late and incurs a penalty charge. Under the new guidance that penalty charge would likely be further consideration for the supply of the hire car and subject to VAT.
- Where the payment relates to a loss that would not be expected in the ordinary course of fulfilling the contract it is likely to be compensatory in nature and outside the scope of UK VAT. HMRC gave the example of a payment made to a car hire company by a customer who has written off the hire car.
- Any damages payments made by the supplier to the customer are likely to remain outside the scope of VAT. However, a retrospective reduction in the charge for the supply should result in a reduction in the amount of VAT due to HMRC from the supplier.
Points one and two are relatively uncontroversial and broadly reflect the decisions of the CJEU in the cases of MEO and Vodafone. Distinguishing between points two and three may not be entirely straightforward in some cases but HMRC’s acceptance that payments provided for in a contract are not subject to VAT in all circumstances is nonetheless welcome.
Another potential area of dispute lies in establishing the purpose of a payment. A payment to compensate the supplier for costs incurred in fulfilling the contract is seen by HMRC as consideration for a supply but they will accept that is not the case where the payment is “clearly punitive and is designed to prevent breach rather than to compensate for lost income”. Presumably objective factors such as the calculation methodology will be more persuasive in determining purpose than subjective factors, i.e. what the parties say. Unhelpfully, contracts will generally avoid using terms such as “punitive” and will often state that such charges are a reasonable pre-estimate of loss (or similar wording) to avoid falling foul of the “penalty rule” for contractual penalty clauses. The practical extent of HMRC’s apparent caveat to their general view is therefore unclear.
In a real estate context, there was concern that HMRC’s revised policy would result in dilapidations being further consideration for a supply of property letting. HMRC’s new guidance expressly states that dilapidations payments will be outside the scope of VAT, other than in limited circumstances where tax avoidance is suspected.
Another concern following the publication of the original September 2020 guidance was the potential impact on break fees in an M&A context. These fees can be significant (up to 1% of the value of the company), and the September 2020 guidance could have given rise to a significant potential VAT liability. The new guidance does not discuss break fees but its general theme (focusing as it does on the early termination of ongoing services) suggests that HMRC is now less likely to see such payments as being subject to VAT.
It remains to be seen how HMRC will apply its new guidance and what view the courts will take with regards to the implications of MEO and Vodafone in the scenarios addressed by the guidance. In the meantime, it is especially important when negotiating contracts that businesses understand the potential VAT implications of termination payments provided for therein and protect their positions accordingly.