Written by Steve Sidkin
5 May 05
It is common for principals to have to pay a sum to their agents upon the termination of an agency agreement. Despite the regularity with which this situation arises, there remains confusion as to the tax status of the payment; both for the principal and the agent. This letter seeks to clarify some of the issues raised and provide a degree of guidance in an uncertain area of law.
The tax consequences for principals
The adverse tax consequences of payments made to an agent under the Regulations can erode the principal's net of tax position considerably.
There are two main areas to consider. First, whether the payment is deductible for the purposes of corporation tax. Second, is the payment subject to VAT?
A payment which is not deductible for tax purposes will increase the net of tax cost of making the payment by up to 43 per cent. Furthermore, under the self-assessment regime, the tax payer must ensure that the manner in which it treats any item of payment is correct. In the event of the treatment being incorrect, significant unmitigable interest, fines and penalties may be levied by the Revenue.
A sum paid in respect of VAT, in circumstances where no VAT is payable, will not be recoverable as input tax by the principal. This is the case whether or not the principal has obtained a "VAT invoice" from the agent.
A VAT return which wrongly claims credit for such payment as input tax may result in substantial interest, fines and penalties. Furthermore, any such sum paid under mistake of law, will not normally be recoverable from the agent. The agent will have accounted for the payment to Customs & Excise as output tax. Customs will not normally refund the overpaid output tax unless it is convinced that there is a legal obligation on the agent to refund the overpayment to the principal.
Is the payment tax deductible for the principal?
Generally, contractual commission payments to agents are tax deductible for the principal.
However, the tax treatment of compensation payments on the termination of an agency agreement depends on the circumstances. Generally, they should be deductible. Occasionally, where the agency is being terminated to bring to an end an onerous obligation, the payment may not be deductible. This could be, for example, where the principal considers that greater sales can be achieved by terminating the relevant agent. There is often uncertainty as to whether or not this is the case.
The question arises whether payments made pursuant to the Regulations on the termination of an agency agreement are compensation for termination or commission payable pursuant to implied terms. The answer is not clear.
Is the payment subject to VAT?
Similarly the VAT treatment of compensation payments is not entirely clear. To the extent that such payments are in respect of services which were supplied by the agent prior to termination, VAT is chargeable. If they are not strictly a payment for any services they should not be subject to VAT. However, Customs take the view that compensation payments may be treated as a payment for the surrender of the right to claim compensation and that this is itself a supply of a service for VAT purposes by the agent and, therefore, subject to VAT. By extra-statutory practice, Customs treat compensation payments as falling outside the VAT net if the payment is made after the commencement of legal proceedings.
The question arises whether any amount payable pursuant to the Regulations following termination of an agency is a compensation payment and, therefore, whether it is subject to VAT.
The tax position of agents
Legislation does not provide a conclusive answer as to the status of payments made to agents under the Regulations, so case law must be used to interpret whether or not the payment is a capital receipt or of a revenue nature. Such a distinction can be important for a variety of reasons. For example, losses brought forward may be available to relieve a trading profit attributable to a payment treated as a revenue payment. Alternatively a payment treated as a capital receipt may qualify for relief from capital gains tax such as taper relief or, roll-over relief where the agent is trading as a company.
It is a question of fact and degree as to whether a payment will be of a capital or revenue nature. The seriousness of the effect on the agent’s business is central to deciding which of the two categories the payment falls into. The more serious the effect of termination on the agent’s business, the more likely it is that the payment is of a capital nature. Equally, if the termination has little effect on the agent’s business, then the payment is more likely to be of a revenue nature.
On the basis that prevention is better than cure, advantage should be taken of opportunities to ensure that an agency agreement meets the two parties’ needs. Unfortunately these may not be the same for each party and may change as time passes.
For the principal it may be prudent to expressly exclude the agent’s rights under the Regulations to certain types of commission and post-termination commission and, if any amounts which may be payable by way of compensation pursuant to the Regulations are likely to be significant, to seek to characterise them as contractual commission payments in order that the principal may secure a tax deduction.
Unless the termination of the contract is so fundamental to the agent’s business that its loss would cripple or destroy the business, the agent is unlikely to secure anything other than treatment of the receipt as a revenue item. The characterisation of the payments will be persuasive but not determinate in agreeing the status of the payment in the agent’s hands with the Revenue. It will always be a question of fact and degree.
Principals should agree to pay VAT on any sum paid, subject to obtaining clearance from their local VAT office that they will be entitled to recover a similar sum as input tax.
Given that such uncertainty exists for both principals and agents, thought should be given to the status of any payments made under the Regulations and advice sought to determine what taxes and reliefs are relevant. Fox Williams has considerable expertise in interpreting the Commercial Agents Regulations and is able to assist both principals and agents in understanding this important issue.
This briefing note is for general information. For advice in applying this general information to your specific circumstances, please contact Stephen Sidkin or any member of the Fox Williams’ agentlaw team (www.agentlaw.co.uk)