HMRC has recently changed its policy in relation to the VAT treatment of early termination fees, including payments made on a breach of or withdrawal from a contract or by way of liquidated damages. In most cases, such payments will now be subject to VAT, regardless of whether the original contract has a right to terminate or the payment is described as compensation or damages.
Further this change of policy is retrospective.
It is common for commercial agency contracts - as well as other commercial contracts such as distribution, franchise, licence and supply contracts - to provide for customers (principals in the case of an agency contract) to have to pay a sum to their supplier (agents) upon the termination of the contract.
Previous HMRC guidance had stated that when customers were charged to withdraw from contracts to provide goods or services, these charges were not generally payments for a supply (being compensatory in nature). Accordingly these payments were outside the scope of VAT although there had been some uncertainty as to the VAT treatment of certain payments so far as agency agreements were concerned.
The change in practice is retrospective, so businesses will need to take action to determine whether they need to correct VAT returns already submitted.
Recent case law and guidance changes
HMRC’s change of policy is set out in Revenue & Customs Brief 12/2020 and follows the recent decisions of the Court of Justice of the European Union (European Court) in Meo (C-295/17) and Vodafone Portugal (C-43/19).
Both of the European Court cases were in the telecommunications sector and related to payments by mobile phone customers under early termination provisions included in their agreements with mobile phone operators. The European Court took an economic approach namely that an operator, in determining its price for the service it provides (and the monthly instalments) and having regard to the costs of that service and the minimum contractual commitment period, must also have taken into account the amount payable in the event of early termination. As such the European Court decided that the amount of any payment on early termination must be an integral part of the price that the customer commits to pay for the operator to fulfil its contractual obligations. Accordingly, the termination fees were part of the taxable supply by the operator. HMRC has also made it clear that early upgrade fees would be seen an early termination fee and treated in the same way as part of the taxable supply, that is subject to VAT!
HMRC’s change in policy, however, applies:
across all business sectors; and
more widely, to all payments made on termination (see below.)
HMRC’s view now is that only in very limited circumstances, where there is no direct link between a payment and an underlying supply of goods or services, will such a payment be outside the scope of VAT. HMRC’s new approach will apply even where there is a separate agreement for the payment or the amount of any payment is not equal to the amount that would have been due had the contract been fulfilled.
Payments on early termination
HMRC’s updated policy will impact most situations where a party is seeking to terminate or withdraw from a contract.
The VAT treatment of any payment made will follow the VAT treatment of the subject matter of the contract. For commercial contracts, in most cases this will be a taxable supply, so subject to VAT. However, as the changes apply to all contracts, the nature of the underlying supply will need to be considered if it may be an exempt or zero-rated supply for VAT purposes.
The changes will also impact:
Commercial Agent Regulations payments – on the basis of HMRC’s new policy, our view is that any argument that a payment of compensation or indemnity made under the Regulations by a principal to an agent on termination of an agency is compensation and so outside the scope of VAT, is likely to be challenged by HMRC, despite the lack of fixed term nature of the arrangement. On this basis, in our view, agents should account for VAT on any such payment received.
Break fees – any recipient of a supply, paying a break fee, on exercising its option to terminate the contract.
Liquidated damages – where early termination provisions in a contract refer to a formula to determine the amount of the payment, such as ‘liquidated damages’ clauses. There is currently uncertainty whether this change goes even further than this and would also apply to liquidated damages payments in contracts paid otherwise than on termination.
Breach of contract – if a contract terminates automatically as result of a breach of contract or other specific event, and a fee is payable, then this will be treated as further consideration under the contract. Whether or not a supplier under an existing contract can charge VAT on top of the contract price will depend on the drafting of the contract - in particular, whether the price was stated to be exclusive or inclusive of VAT (if the contract is silent on VAT, any payment thereunder is deemed to VAT inclusive).
Retrospective nature of the changes
Controversially, this change of policy is retrospective, with HMRC suggesting that suppliers who have failed to account for VAT on these payments should correct the position.
HMRC has not, however, said how far back they expect taxpayers to go, which could mean that taxpayers need to look at transactions going back four years.
What does this mean going forward?
It is hoped that HMRC will quickly clarify a number of questions resulting from its surprise announcement.
In the meantime, businesses that have failed to account for VAT to HMRC on early termination fees or compensation payments received on termination of a contract should consider whether they need to amend past returns (and potentially seek further payments in respect of VAT from counterparties). Businesses should also review their existing contracts to evaluate whether and how the allocation of VAT on early termination fees is specifically dealt with in such contracts.
Going forward, businesses should address carefully whether payments arising in connection with early termination of contracts will be subject to an additional 20% VAT and explicitly address the allocation of VAT in such situations in their contracts.
The changes will be expensive for some businesses (and their customers). Working out who bears the burden of any adjustment, considering the contractual position, and the overall impact on VAT recovery may also be complex.