Updated guidance on early termination and compensation payments - impact for real estate

Background and summary

Following the CJEU decisions in Vodafone Portugal (C-43/19) and MEO (C-295/17), HMRC has surprisingly changed its published guidance to make it clear that early termination and compensation payments relating to commercial contracts are in most cases consideration for goods or services and subject to VAT (see Revenue and Customs Brief 12 (2020)).

In meetings with the BPF, it apparently became clear that HMRC had not appreciated the impact for the real estate sector. Although HMRC have now clarified their view on the impact for payments by tenants (and landlords) following the exercise of break rights in a lease, the position regarding dilapidations payments, and interest on late rents is still unclear. Of most concern, however, is HMRC's intention to apply this practice retrospectively, and BPF are rightly challenging this intention as one which undermines confidence in the rule of law and certainty.

This bulletin gives the latest position, both generally and for the real estate sector specifically.

Are HMRC correct in their change of practice on compensation payments?

HMRC's previous guidance stated that a customer's payment to withdraw from an agreement to receive supplies of goods or services under a "right to terminate" could generally be viewed as compensation and outside the scope of VAT. If a compensation payment clearly related to unpaid invoices or access to future services, then VAT would be applicable.

HMRC's updated guidance states that the following types of payments made by customers, regardless of whether they are made in exercise of a "right to terminate" or are described "compensation" or "damages" are to be treated as consideration and subject to VAT:

• early termination payments (e.g. early exit or upgrade fees for mobile telephone packages);
• liquidated damages (e.g. amounts paid under a contract expressed to be "compensation" for loss of earnings);
• payments to end a lease agreement (e.g. early termination fee paid by lessee under vehicle finance lease);
• payments for breach of contract (e.g. early termination fee payable upon business going into receivership.

These are likely to affect hire purchase agreements, outsourcing contracts, and settlement agreements, for example.

HMRC have based their change of practice on two Court of Justice cases, which have nothing to do with real estate. In MEO, the telecommunication services contract stated that on early termination, the customer was to pay a fixed sum representing the remaining amounts payable for the minimum commitment period. The CJEU held that the termination payment was consideration for the right to receive the services which the customer chose not to use. Early termination did not alter the economic reality of the relationship, as the sums payable were the same.

In Vodafone Portugal, the method for calculating the termination payment under the telecommunication services contract was restricted under Portuguese law to Vodafone's cost of providing the service. Vodafone therefore sought to distinguish its case from MEO by arguing that the payment was intended as genuine compensation. The CJEU held that the character of the payment did not change to compensation because from an economic perspective, the amount payable on early termination was an integral part of the price which the customer agreed to pay under the contract. The payment was therefore consideration and subject to VAT.

It is worth stating that the MEO and Vodafone cases were decided on their facts, and they were cases where the compensation payments were made in accordance with the termination rights in a contract, and could be properly construed as payments for the availability of the telecoms service. To generalise and treat these cases as reflecting principles applicable to compensation payments generally is surprising.

As a result of HMRC's updated guidance, there are likely to be wide ramifications and fewer situations where HMRC will accept that early termination and cancellation fees, however expressed, genuinely fall to be treated as compensation and not subject to VAT. The description of the payment as liquidated damages or compensation does not matter. It also does not matter if the payment is made under the contract or a separate agreement is reached. HMRC will take this view where the payments result from events envisaged under the contract. A customer's payment may only be outside the scope of VAT where it does not have a direct link to a supply of goods or services.

Impact for real estate industry

The fact that HMRC had not considered the impact for the real estate industry is worrying. In these difficult times where there is so much uncertainty for landlords and tenants, this change of practice has only made things worse.

Most compensation payments are made in connection with lease transactions. Following an urgent meeting with the BPF, we understand that HMRC's initial position is as follows:

• Payments by tenants following the exercise of break rights - exempt but taxable if the landlord has opted to tax.
• Payments by developers wanting to back out of an obligation to take a lease - exempt, but taxable if the landlord has opted to tax.
• Payments by landlords exercising contractual break rights - HMRC consider these are exempt subject to the tenant opting to tax, but HMRC want to consider further.
• Dilapidations payments made by a tenant at the end of a lease - probably outside the scope of VAT (as compensation paid by a tenant for its breach of the repair covenant), but HMRC want to consider further.
• Interest for late payment of rent - HMRC wish to consider further. The issue here is whether the interest is further consideration for the supply of the property (like the rent), subject to the landlord's option to tax.

Where HMRC's position is uncertain, taxpayers should protect their position by charging VAT on top of the compensation, and agreeing to refund the VAT and issue a credit note valid for VAT purposes, if it turns out it was not properly chargeable. Exempt and partially exempt taxpayers may wish to take the cost of the irrecoverable VAT into account on agreeing the compensation amount.

Retrospection

HMRC have stated both in the Revenue & Customs Brief and to the BPF that in their view taxpayers should adjust for past errors, or they might get an assessment. Logically this would be four years back in line with the "error" rules, but it is not clear. The BPF are strongly protesting against this as it undermines certainty and confidence in the rule of law, and of course the parties may have a legitimate expectation for the previous outside the scope of VAT treatment if they relied on clear guidance. Nevertheless, if taxpayers received payments of compensation but no VAT was charged and have the benefit of a VAT clause obliging the payer to pay VAT on top, they should now consider asking the payer to pay VAT on top. A credit note can always be issued to cancel the VAT charge if HMRC change their minds.

If a written ruling from HMRC was obtained at the time, after full disclosure of the facts, HMRC will not be able to insist on retrospective adjustments.

Conclusion

For the future, taxpayers should ensure that VAT is properly considered in agreeing termination payments. Exempt and partially exempt businesses will want to build this into the amount agreed.

For the past, taxpayers should review compensation payments received over the last four years, to see if there is an ability to charge VAT. It is hoped that HMRC back down, and agree (as is normally the case) that the change in practice is not retrospective. But otherwise, subject to legitimate expectation claims, some taxpayers may end up with a shortfall, if they are liable to account for the VAT out of the monies received, and payers of compensation may conceivably benefit from a windfall, if they are entitled to receive a VAT invoice and reclaim VAT, forming part of the amount they paid.

For specific cases, and particularly where there is uncertainty, please do not hesitate to contact the DLA Piper Tax Team.