VAT and early termination payments

The ECJ has held that payments received by a business from a customer for early termination of a contract with a minimum tie-in period constitute consideration for a supply of services by that business, irrespective of whether the amount paid relates to the remainder of the contractual price: Vodafone Portugal v Autoridade Tributária e Aduaneira (Case C 43/19) (ECJ, 11 June 2020). The decision extends the earlier case law of the ECJ beyond circumstances where the payment was, in essence, similar to the amounts that would have been paid by the customer had the contract not been terminated.

The decision calls into question the treatment of contractual termination payments generally, suggesting that many such payments should be regarded as part of the consideration agreed for the supply of services to the customer under the terms originally agreed. As such, it may be necessary for HMRC to reconsider their guidance on this point, which currently generally treats contractual termination payments as outside the scope of VAT.

Background

The case involved supplies of electronic communications services, fixed telephony and wireless internet access by Vodafone Portugal to customers. Vodafone offered contracts including special promotions (usually involving discounted pricing) subject to conditions which tied those customers in for a minimum period (the tie-in period). Failure by customers to comply with the tie-in period required them to pay fixed amounts provided for in the contracts.

In the earlier ECJ decision of MEO (Case C 295/17), the court held that the payment of a fixed amount as an early termination payment in similar circumstances amounted to consideration for the supply of services by the supplier. However, in that case, the amount paid by the customer was, in essence, the remainder of the contractual price for the agreed contractual period. See VAT treatment of minimum fixed service fee.

In this case, Portuguese law limited the amount of compensation that a provider could charge to a customer on early termination of a contract to the benefits granted to those customers under the contracts and for which, on the date of termination, the supplier had not been compensated. The amount to be paid in cases of non-compliance with the tie-in period was required to be calculated in proportion to the completed part of the tie-in period, and that amount may not exceed the costs incurred by Vodafone for the purposes of installing the service. As such, unlike in the MEO case, the amounts paid by way of compensation on early termination of the contract could not simply be the amounts that would fall due under the contract if it were not terminated.

The Portuguese courts referred the question of the correct treatment of the termination payments to the ECJ, noting this difference with the MEO case. Must amounts received by Vodafone in the event of early termination of a services contract requiring compliance with a tie-in period in exchange for granting that customer advantageous commercial conditions, be considered to constitute the consideration for a supply of services?

Decision of the ECJ

The ECJ has held that in these circumstances the termination payment does amount to consideration for the supply of services under the contract by Vodafone and the fact that the amounts paid did not simply relate to the outstanding amounts due under the full contractual period did not detract from that position.

The Court noted that there must be a direct link between the service supplied and the payment received for it to amount to consideration from a VAT perspective. And it was clear from the MEO case that this test was met in relation to a predetermined amount received by supplier where a contract for the supply of services with a minimum commitment period is terminated early by its customer, even though that termination results in the end of the provision of the goods and services concerned.

By analogy with the MEO case, the Court held that “the consideration for the amount paid by the customer to Vodafone is constituted by the customer’s right to benefit from the fulfilment, by Vodafone, of the obligations under the services contract, even if the customer does not wish to avail himself or herself or cannot avail himself or herself of that right”. In essence, Vodafone puts the customer in a position to benefit from the supply of services and commits to provide those services as agreed in the contracts, subject to the conditions stipulated in those contracts. Vodafone’s customers commit to paying the monthly instalments provided for under those contracts and also, if necessary, the termination amounts due where those contracts were ended before the end of the tie-in period. Those termination payments reflect the recovery of some of the costs associated with the supply of the services which Vodafone has provided to those customers and which they committed to reimbursing in the event of such a termination. As such, those amounts must be considered to represent part of the cost of the service which the provider committed to supplying to its customers where the tie-in period is not complied.

The ECJ concluded that, “from the perspective of economic reality, which constitutes a fundamental criterion for the application of the common system of VAT”, the amount due upon the early termination of the contract guarantees the operator a minimum contractual remuneration for the services it has provided. Those payments, therefore, constituted part of the consideration received by Vodafone for the services it provided. It was irrelevant that, unlike the amounts in the MEO case, the payments were not the equivalent of the amounts that Vodafone would have been received if the customer had not terminated the contract early.

The ECJ also rejected Vodafone’s argument that the payments should be classified as compensation outside the scope of VAT. First the Court noted that argument ran counter to the position of the national law since, under that law, a supplier was not able to charge to its customer sums by way of compensation or indemnification, in the event of early termination. Moreover, that argument could not succeed either in the light of the economic reality of the case. “In the context of an economic approach, an operator determines the price for its service and monthly instalments, having regard to the costs of that service and the minimum contractual commitment period…. the amount payable in the event of early termination must be considered an integral part of the price which the customer committed to paying for the provider to fulfil its contractual obligations.”

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 adopted an approach based on the commercial and economic reality to conclude that a provider receiving exactly the same payment from the customer terminating the contract as one continuing to enjoy the services for the minimum period was receiving that payment as consideration for its supplies. The Vodafone Portugal case takes this analysis one step further and may suggest that any fixed contractual termination payment should be seen as the part of the price agreed by the customer for the services it receives under that contract.

The decision therefore calls into question HMRC’s practice of regarding contractual termination payments as not being consideration for a supply as set out in their VAT Manuals (VATSC06720). Whilst it may be the case that the Manual is correct in asserting that there is no consideration for the right to terminate early in such circumstances, it seems from the Vodafone decision that a much more careful analysis is necessary to determine whether the termination payment should correctly be regarded as part of the wider price agreed by the customer for the provision of the services generally under the relevant contract. It will be interesting to see what approach HMRC take to these decisions.