VAT treatment for early termination charges, compensation and dilapidation payments

After a period of uncertainty, HMRC have clarified the VAT treatment of early termination charges, compensation and dilapidation payments.

Background

Historically, HMRC had the view that, when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and therefore, charges were outside the scope of VAT. These charges were often expressed as being compensation for loss of earnings, i.e. liquidated damages.

However, in September 2020 following the CJEU judgments in Meo (C-295/17) and Vodafone Portugal (C-43/19), HMRC issued a Revenue and Customs Brief (RCB), which set out their revised policy, where most early termination fees and some cancellation fees due under a contract, were liable for VAT if the underlying goods or services, were subject to VAT (even if they are described as compensation or damages).  Further, the RCB stated that HMRC considered that dilapidation payments were additional payments for rent, and potentially subject to VAT.

The RCB received sector wide criticism, both in terms of the scope of HMRC’s interpretation and proposals to backdate the proposals.  The guidance was temporarily withdrawn in January 2021, pending review.

HMRC’s Current Position

The updated RCB issued February 2022, together with new guidance confirms HMRC’s position, and states that taxpayers must adopt the new guidance from no later than 1 April 2022.

In its guidance, HMRC clarifies its position on:

• When compensation payments are consideration for a supply?
• When VAT will be due on early termination contracts and liquidated damages.

Whether a payment is subject to VAT will depend on the economic reality.

Broadly, payments that are made as a result of events provided for under the contract (i.e. liquidated damages for terminating a lease early, or payments to compensate a supplier if a customer fails to make payment on a goods or services which were made available to that customer) are further consideration for the main supply, and will be subject to VAT in the same way as the underlying supply.

If the fee is at such a level that it is clearly designed to prevent breach rather than to compensate for loss, then the link between the payments and the supply is not sufficient to regard it as additional consideration and will remain outside the scope of VAT.

Dilapidation payments

VAT and dilapidation payments are a particularly complex area for in the property and construction sector. Essentially, they ensure landlords are compensated when buildings are not returned in the agreed condition. The question to be addressed is whether the payment is sufficiently linked to the supply of the lease.

HMRC’s view is that in most cases, the lease itself does not create the obligation to make a dilapidation payment. Rather, it is the default on the obligation to return the property in the agreed state, that gives rise to the requirement to make a dilapidation payment. Therefore, the link between payment and supply cannot be established, and so dilapidation payments remain outside the scope of VAT. HMRC may, however, depart from this view, if, in individual cases, they find evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.

Next steps

Businesses must ensure that they adhere to the new rules from 1 April 2022.  Affected parties should ensure that:

• Their teams understand how the updated rules impact both supplies by, and goods and services consumed by the business
• Contracts and other documentation reflect the new technical position, and protect the business – for example businesses should avoid (i) VAT inclusive prices, and (ii) re-using old contracts which state early termination payments are outside of the scope of VAT
• Invoices bearing VAT incorrectly charged, are challenged (this isn’t input VAT and can’t be recovered)
• “Errors” corrected following RCB 12 (2020) are ‘reversed’ within the timescales (usually four years from the date of the error).

If you would like to discuss the impact of the changes, please contact Gemma.McCaldon-Gower@cowgills.co.uk, your usual Cowgills contact or get in touch with us on our website.