VAT treatment of minimum fixed service fee

UPDATE: in the Vodafone Portugal case (Case C 43/19), the ECJ has extended the application of this reasoning to compensation for early termination which was not a similar amount to that which would have been paid under the original contract had it continued. See VAT and early termination payments.

The ECJ has held that where a business charges a customer a compensation fee for early termination of a contract in an amount which is the same as if the contract had continued for the agreed minimum period, then those payments are consideration for services and subject to VAT: MEO - Serviços de Comunicações e Multimédia SA v Autoridade Tributária e Aduaneira (Case C 295/17). The Court considered that the economic and commercial reality of such early termination arrangements indicated that the payments were consideration for VAT purposes. To hold otherwise would be to distinguish between customers who used the service for the full minimum contractual period and those who terminated early but were still obliged to pay the same total charge.

The decision (which is not currently available in English) takes a pragmatic and commercial approach to the classification of the payments in this case, but leaves open for debate to what extent a payment might have to differ from the agreed contractual amount in order to be treated as a true compensation payment for VAT purposes.

Background

MEO, a Portuguese company, provided telecommunication services. Agreements between MEO and its customers required the customer to pay for a minimum term period in monthly instalments. Where payments were not made in accordance with the contract by the customer or the customer otherwise wished to resile from the contract then, under the terms of the contract, the customer was required to pay an amount equal to the monthly amount multiplied by the number of months which remained to the end of the minimum contract period. MEO did not continue to provide telecom services for the minimum period in those circumstances and MEO did not charge VAT on such a payment, treating it as a compensation payment outside the scope of VAT.

The Portuguese tax authorities considered that the payments made by customers in these circumstances were not compensation but were consideration for a supply of services and MEO should have accounted for VAT on them. The case was referred to the ECJ by the Portuguese courts where Portugal was supported by Ireland and the EU Commission.

Decision of the ECJ

There have been a number of earlier ECJ decisions dealing with the VAT treatment of compensation payments. In particular, in Société thermale d’Eugénie-les-Bains (Case C-277/05) the court held that a forfeited deposit was not consideration for a supply of services. However, this scenario has been distinguished from the situation where a person buys a ticket for a service (such as a flight) but then simply does not use the ticket. In such a case, the customer has paid for the right to receive the service and that in itself gives rise to a taxable supply (Air France - KLM (Case C-250/14). The question in this case was, therefore, fundamentally whether the payments made by customers on early termination of the contract were consideration for a supply or simply compensation without any supply being made.

The ECJ pointed out that, although the contractual terms are important in classifying a transaction, so is the economic and commercial reality of the situation. In this regard, the ECJ stressed that, since the amount payable by the customer was the full monthly fee up to the minimum contract period, MEO would, in principle, receive the same amount as if the customer had not terminated the contract early. (Indeed, one of the purposes of the provision was to deter customers from cancelling a contract early on the basis that they would be liable to pay the same amount as if they kept the contract in place to the end of the minimum period.).

Moreover, the court stressed that if the payments by a customer were treated as a compensation payment, then this would lead to a difference in treatment between a customer who used the service for the whole of the minimum contract period and one who terminates the contract early, even though they paid the same amount.

These factors pointed to the conclusion that where a customer makes a payment of a predetermined amount under a minimum service period contract which is equal to the amount that would have been paid had the contract continued, then that is consideration for a taxable supply of services. The terms of this contract are set out from the outset. In essence, the ECJ’s analysis appears similar to the decision in Esporta, in which the Court of Appeal held that where a person joining a sports club was contractually committed from the outset to pay for twelve months membership, the payments made under the contract were consideration for agreeing to make available the facilities under the terms of the contract and therefore the fact that persons paying late were denied access did not prevent the payments continuing to be consideration for supplies. See Late paid fees and VAT.

The court went on to say that the conclusion was not affected by the fact that the purpose of the imposition of the requirement to pay in full for the minimum period was to dissuade customers from terminating the contract early and compensate the provider for loss suffered. The question of what amounts to a supply for a consideration is not affected by the purpose of the measure. In any event, the ECJ agreed with the AG’s analysis that the purpose of the payment in this case was, from an economic perspective, to provide a contractually fixed minimum consideration for MEO.

The court also confirmed that the legal classification of the payment under national law was not relevant. The fact that the payment might be classified as a fine, for example, was irrelevant. The question whether a payment is consideration for a service is a matter for EU law, not national law.

Finally, the court confirmed that the fact that higher commission payments may be payable under contracts with a minimum term compared to those without a minimum term was also not a relevant consideration.

Comment

The VAT treatment of compensation payments - and, in particular, contractual termination payments – has long been a problematic issue. In the UK, the question of the correct VAT treatment of an agreed compensation payment for termination of a contract was left in an ambiguous state by the decisions in Croydon Hotel & Leisure Company Ltd v C&EComrs (VAT tribunal decision 14920) and Holiday Inns(UK) Ltd v C&E Comrs (VAT tribunal decision 10609), in which different tribunals reached opposite conclusions on the VAT treatment of the same payment under a contract for early termination of a hotel management agreement. Differentiating between a payment that amounts to compensation for breach of contract rather than consideration for a supply is not always straightforward.

In the MEO case, the ECJ has adopted an approach that appears to be very specific to the facts. Whilst confirming that the contractual provisions are important, the court seemingly gave overriding importance to the “commercial and economic reality” of the provider receiving exactly the same payment from the customer terminating the contract as one continuing to enjoy the services for the minimum period. Of course, that leaves open the question how much of a difference there would need to be for a smaller termination payment to amount to compensation rather than consideration for a supply.

Factually, the case is similar to the Esporta case in the UK, where the UK Court of Appeal reached the same conclusion, albeit based on a contractual analysis of what the payment was for rather than an application of the “commercial and economic reality”. Ultimately, it seems that it will be difficult to argue that a customer who is obliged to pay an agreed, fixed fee for a minimum period is paying anything other than consideration for an agreed supply (whether they actually choose to make use of the facilities available for the whole period or indeed are able to do so).