VAT on liquidated damages and compensation payments

HMRC has recently revised its guidance on compensation payments (including liquidated damages) made on the early termination of contracts, with the result that many compensation payments, which have been treated as outside the scope of VAT in the past, in line with Revenue guidance, may now be treated as consideration for a taxable (or exempt) supply for VAT purposes.

Importantly, HMRC states that any taxable person that has failed to account for VAT to HMRC on such fees should correct the "error", potentially requiring VAT amendments going back up to four years.

In the past, HMRC's position was that payments charged to customers for the early termination of agreements to receive goods or services were not VATable.  Revenue and Customs Brief 12 (2020) and associated guidance (in VATSC05910, VATSC05920 and VATSC05930) have now been published, stating that early contract termination fees, including payments on a breach or withdrawal of a contract and liquidated damages, are subject to VAT. However, the associated published guidance is drawn very widely and has also raised concerns about the treatment of other compensation and damages payments.

Payments now in scope

The CJEU cases which triggered this change concerned payments made by customers to their suppliers, in order for the customer to exit the contract early. In those cases, the payments by the customer were held to be further consideration for the supplies made by the supplier under the contract. 

On the basis of this reasoning, and noting the very specific context of HMRC's Brief (being explicitly addressed to businesses charging their customers to withdraw from agreements to supply goods or services), we consider that only payments passing from the recipient of a supply (i.e. the "customer") to the supplier on the early termination of a contract are expressly within its scope. Other payments, for example liquidated damages payable by the supplier as a result of delay, should not be categorised as "further consideration" for the supply under the contract because it is not the customer making supplies under the contract, it is the supplier.  

(That is not to say that payments passing from the supplier to the customer can never be VATable. In some circumstances, for example the surrender of a lease, there may be a separate supply made by the customer but the VAT treatment will depend on the exact contractual arrangements and is not affected by this Brief.)

We note, however, that the updated guidance is drafted widely and, in places, appears to refer to any compensatory payments envisaged under a contract. Various advisory firms and industry bodies are urgently seeking clarification on this, as well as the retrospective nature of the guidance, and we will update you further on the outcome of this. Having said all that, though, we would emphasise that HMRC's newly published guidance does not have the force of law.  Moreover, the two CJEU decisions that are discussed in this guidance are perhaps not hugely surprising on their specific facts.  So, in each case, the VAT treatment should in our view be determined by reference to whether the relevant compensation or damages payment, regardless of its label, is consideration for a supply by the recipient and, if so, whether that supply is taxable or exempt for VAT purposes.

To summarise:

1. A payment made by a customer to withdraw from a contract will usually be taxable if the underlying supplies made by the supplier to the customer under the contract are taxable supplies. This will include termination and cancellation fees, liquidated damages, payments for termination on breach of contract, upgrade fees and lease termination contracts.
2. This VAT analysis is not affected by the categorisation of payments e.g. as compensation, damages or penalties, nor will it matter how the payments are calculated (e.g. it is irrelevant whether the sum corresponds to the amount foregone under the contract) nor whether the right to terminate is found in the contract or negotiated separately.
3. HMRC do not expressly discuss the treatment of withdrawal fees where the supplies made by the supplier under the contract are exempt or zero rated, but applying the same principle we would expect such fees to be treated as exempt or zero rated.
4. The extent to which HMRC intended to change their stated view of the VAT treatment of damages or termination payments (other than those at heads 1 – 3 above) remains uncertain.

What types of payments need be considered?

The CJEU cases referenced in HMRC's Brief related to the provision of telecoms services, where payments to exit contracts before the end of a minimum commitment period are common. The guidance, however, is not restricted to specific contexts and potentially applies widely, for example:

In the context of Projects and Corporate transactions, the following types of payment should be considered carefully from a VAT perspective:

• Termination payments;
• Liquidated damages payments;
• Compensation arrangements under payment mechanics provisions; and
• Step in payments.

In the Real Estate and Construction sector, HMRC's guidance should be considered carefully in the context of the following types of payments:

• Break payments under leases (whether contained in the lease or otherwise);
• Forfeited contractual deposits;
• Dilapidations payments; and
• Liquidated damages payable pursuant to development agreements and agreements for lease.

What next

Taxpayers who are affected should consider obtaining advice about the implications of this updated guidance on liquidated damages/compensation payments that they have paid or received. As well as accounting for VAT received or deemed to be received, it may also be possible for customers to recover VAT on termination payments made by them on a VAT inclusive basis. 

Recipients of compensation or damages payments should take advice before agreeing to a settlement on a VAT inclusive basis.  Compliance with these requirements may also need to be assessed in the context of due diligence reviews of businesses which have received material sums as compensation or termination payments.

HMRC expects any taxable person that has failed to account for VAT to HMRC on such fees to correct the "error" unless they have a specific ruling from HMRC to the effect that such fees are outside the scope of VAT. Clients may need advice as to whether they are required to, or should choose to, do so.  If they did follow this HMRC guidance, this would require checking all early termination payments in the last four years (unless HMRC rows back on the retrospective application of this guidance) and invoicing and accounting for VAT + interest where necessary. There may also be some cases where it would be worth challenging this change of position by HMRC, whether by judicial review or otherwise. 

Going forward, it will be crucial to ensure that contracts address whether VAT is expected to be due on payments and how this should be allocated and existing contracts should be reviewed. More generally, this highlights the importance of considering the inclusion of a VAT allocation clause in all contracts which contain termination, compensation or reimbursement provisions, even where VAT is not expected to be in scope.  

Please do not hesitate to raise any questions on this with any member of the Ashurst Tax team.