VAT on early termination and compensation payments

In September 2020, following two Court of Justice cases, referred to below, HMRC published controversial and ill-thought through guidance changing its long-standing policy on the VAT treatment of early termination fees and compensation payments. Following many dissatisfied responses, HMRC agreed in January 2021 to withdraw and replace this guidance. The replacement guidance has finally arrived, Revenue Brief 2/2022, and HMRC’s revised position is much closer to the impact of these two Court of Justice cases, without the wider ramifications.

HMRC noted in January 2021 that until it produced new guidance, taxpayers were permitted to apply their previous VAT policy. Now this guidance has been published, HMRC has asked taxpayers to apply it from no later than 1 April 2022.

What has changed?

Historically, as a general rule, HMRC did not treat early termination and compensation payments as being subject to VAT. This was on the basis that such payments were not consideration for a supply.

However, following the CJEU decisions in MEO (C-295/17) and Vodafone Portugal (C-43/19), HMRC issued guidance which stated that most early termination and compensation payments are further consideration for the contracted supplies and so potentially subject to VAT. (See our earlier article for a brief description of these cases.) Whether such payments are subject to VAT will depend on whether the relevant supplies are VATable. The principle here is that where the payment represents compensation for what would have been taxable services under a contract, VAT should still be charged, even though those services will no longer be supplied following the termination of the contract. It is a question of looking at the contract, and the underlying economic and commercial reality, and establishing the commercial rationale for the payments. Therefore, the following types of payments will generally be treated as subject to VAT (regardless of whether they are made in exercise of a “right to terminate” or are described as “compensation” or “damages”).

• early termination payments under a contract or lease (e.g. voluntary prepayment);
• liquidated damages (e.g. amounts paid under a contract for goods or services expressed to be "compensation" or for "loss of earnings"); and
• early upgrade fees.

Where there is no direct link between a payment and a supply, HMRC accept that the payment will not be consideration and so not subject to VAT. For example, when a customer pays an agreed contractual penalty for writing off a hire car, there is no direct link between the penalty and any supply of use of the car and so no VAT is due. Whereas, as per the general rule, where the customer pays a penalty for late return, the penalty is, as a matter of economic and commercial reality, effectively consideration for the extended use of the car, albeit not agreed in the contract, and therefore attracts VAT.

What did HMRC cover in their new update this month?

As predicted in our earlier article on the topic, HMRC have now clarified that dilapidations payments at the expiry of a lease will generally remain outside the scope of VAT as compensation for the tenant’s breach of its covenant to keep the property in a good state of repair. They are generally not compensation for use of the property (which may be taxable if the rent is taxable) but rather compensation to the landlord for the tenant’s breach of the repair covenant. However, HMRC state that they may deviate from this policy where there is evidence of value shifting from rent to dilapidations payments to avoid accounting for VAT on the rents.

Do the Courts agree with HMRC’s new policy?

In a recent Scottish case, Ventgrove ([2021] CSOH 129), the Court considered the VAT treatment of a break payment paid by a tenant on the exercise of a break option in a lease. The rent was liable to VAT but the Court decided that no VAT was payable on the break payment, where the break payment was considerably less than the rent which would have been paid had the lease continued. It was held that the MEO and Vodafone cases were not directly in point because they relate to compensation for payments the supplier would have received under the contract or for costs they incurred due to the customers’ failure to complete a minimum contractual term, whereas Ventgrove concerned the exercise of a contractual entitlement to bring a contract to an end upon payment of a fee.

The Ventgrove case is of course of particular relevance to agreed break fees, when the tenant has a contractual entitlement to break, suggesting that these may be outside the scope of VAT at least where the payment bears little correlation with what the contractual payments would have been (whether they are far higher or lower). Until the position is clarified, a tenant may benefit from seeking an HMRC ruling if it cannot recover all its VAT.

However, another recent case suggests that HMRC’s new policy may not go far enough. The CJEU held in Apcoa (C‑90/20) that private car parking penalties were subject to VAT because they were effectively consideration for the supply of parking, despite the penalties being punitive. It seems that whether the provider actually intended to supply such parking was irrelevant (for example, where a car was parked on an emergency route or in a disabled space). This is contrary to HMRC’s new guidance which says that such fees can only be subject to VAT if they are effectively payments for a permitted extension to the parking period, but are outside the scope of VAT where the amounts are “substantial and punitive” and designed to deter a breach of the terms and conditions. Accordingly, care should be taken with substantial penalties as well as smaller ones.

Next steps

Businesses contracting to receive forms of compensation should ensure that any new contracts expressly enable them to charge VAT in addition to all such payments, as compensation will be deemed inclusive of VAT unless the agreement provides otherwise.

HMRC’s initial policy revision in September 2020 suggested that dilapidations payments were subject to VAT. Any business that adopted this treatment and accounted for VAT on dilapidations payments can now correct this using the normal methods for VAT error corrections. Where the tenant has been unable to reclaim all the VAT charged, the tenant may encourage the landlord to correct the position and refund the VAT with a credit note.

From 1 April 2022, although some uncertainty remains, there will be fewer situations where HMRC accept that early termination and compensation payments, however expressed, genuinely fall to be treated as compensation and not subject to VAT. This is the case even where HMRC have given a business a ruling that such fees are outside the scope of VAT. However, a customer’s payment will still be outside the scope of VAT where it does not have a direct link to an underlying supply of goods or services, as a matter of the agreed contractual terms and the economic and commercial reality as to what the payment actually represents.

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