Updated guidance on early termination and compensation payments

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

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.

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 generally to be treated as consideration and subject to VAT:

• early termination payments (e.g. early exit fees);
• liquidated damages (e.g. amounts paid under a contract expressed to be compensation);
• 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) – this however will not be the case if the damages cannot be linked to a supply of goods or services.

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.

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 arguing that the payment was intended as 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 the customer agreed to pay under the contract. The payment was therefore consideration and subject to VAT.

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. However, a customer’s payment may be outside the scope of VAT where it does not have a direct link to a supply of goods or services.

In the real estate context, we believe that dilapidations payments by a tenant at the expiry of a lease will generally remain outside the scope of VAT as being compensation for the breach of the tenant’s covenant to keep the property in a good state of repair. However, the VAT treatment of a tenant’s payment following the exercise of a break clause in a lease may be within the new guidance, and the British Property Federation is urgently seeking clarification.

HMRC has also called for businesses to take corrective action for any VAT that has not been properly accounted for past periods. Given HMRC’s earlier contradictory guidance, businesses may be able to resist taking corrective action depending on their specific circumstances.

Next steps

Businesses should ensure that any new contracts expressly enable VAT to be charged in addition to all such payments. A general VAT clause, permitting the supplier to charge VAT on top of all payments, should suffice. Such contracts will include:

• Lease agreements;
• Hire purchase agreements;
• Outsourcing contracts;
• Other contracts involving continuous supplies of services;
• Settlement agreements.

Some businesses may find themselves in a better position than others where the contract is silent on VAT. In such cases, the charges are deemed inclusive of VAT. This could mean that:

• The customer making the payment benefits from a windfall – it may be able to ask for a VAT invoice and deduct a proportion of VAT that it may not have otherwise done;
• The business receiving the payment may be liable to a shortfall – it may be liable to account for VAT on the sum received which it cannot recover from the customer.

In relation to the past, businesses may want to address whether corrective action should be taken. Cases may be complex, but particularly where the contract allowed VAT to be charged in addition, businesses may want to approach their customers for the payment of VAT.

There are significant consequences for all affected businesses and different strategies to deal with the tax situation, depending very much on the facts.

Should you have any queries, please reach out to the authors below.