HMRC revised guidance on contractual termination payments

HMRC has finally published its updated guidance on the VAT treatment of early termination payments in Revenue & Customs Brief 2 (2022) following the earlier suspension of R&C Brief 12/20. The change in guidance follows recent decisions of the ECJ which were contradictory to earlier HMRC guidance. The guidance takes the view that most contractual termination payments and early termination fees will now be subject to VAT, whether or not they have been described as compensation or liquidated damages, on the basis that they amount to additional consideration for the underlying supply. Equally, however, the updated guidance now recognises that there will be some cases where payments do not constitute additional consideration for the underlying supply where a case by case approach will be necessary. Importantly, the guidance now accepts that dilapidation payments will normally be outside the scope of VAT.

Businesses should consider whether they are affected by the change of policy which they will need to adopt by no later than 1 April 2022.  

Background

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&E Comrs (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 recent MEO case (Case C-295/17), 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. Subsequently, the Vodafone Portugal case (Case C-43/19) took this analysis one step further suggesting 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. For further information on these cases, see "VAT and early termination payments".

These decisions, therefore, called into question HMRC's practice set out in their VAT Manuals (VATSC06720) of regarding contractual termination payments as being outside the scope of VAT. As a result, HMRC issued R&C Brief 12 (2020) in September 2020 reversing their earlier policy and setting out their view that, as a result of the ECJ decisions, all contractual early termination payment or liquidated damages would amount to additional consideration for the underlying supply made by the supplier for VAT purposes. The change in policy was heavily criticised and this resulted in HMRC suspending the effect of R&C Brief 12 (2020) in January 2021, pending a further review of the position.  

Revenue & Customs Brief 2 (2022)

The revised guidance now published by HMRC still represents a reversal of HMRC's earlier policy in this area, but is now somewhat more nuanced and accepts that there will be some cases where compensation payments fall outside the scope of VAT.

The guidance states that the recent ECJ decisions show that when customers are charged to withdraw from agreements to receive goods or services, "it is evident that these charges are normally considered as being for the supply of goods or services for which the customer has been contracted for". As a result, HMRC state that most early termination and cancellation fees are therefore liable for VAT, even if they are described as compensation or damages. The revised guidance does, however, now explicitly state that this is the case only if the goods or services for which the fees have been paid are liable for VAT.

The new guidance is more fully set out in the VAT Manuals at VATSC05910, VATSC05920 and VATSC05930. This guidance states that HMRC's policy is to treat payments arising out of early contract termination as consideration for a taxable supply both where the original contract allows for such a termination, as well as when a separate agreement is reached. In particular, any liquidated damages required by a contract will, in most cases, be seen as consideration for a supply. Although the payments are designed to compensate, they are made as a result of events envisaged under the contract and are therefore part of the agreement and if they form costs to the supplier of making the supply available or equate to what would have been charged for the supply had it run as expected they may be further consideration for the supply.

However, the guidance does now accept that not all termination payments provided for under a contract will necessarily be consideration for VAT purposes. There is now an emphasis on the need for a clear link between the payment and the supplies made under the relevant contract. For example, where a fee or charge is "clearly punitive and is designed to prevent breach rather than to compensate for lost income, then the link between that payment and the supply is not sufficient to regard it as additional consideration, and it will be outside the scope of VAT".  

In addition, the guidance also (grudgingly perhaps) accepts that dilapidation payments made by a tenant at the end of a lease to compensate a landlord for failure to keep the property in the agreed state will remain outside the scope of VAT. The guidance sets out argument for and against this position, but ultimately accepts that HMRC policy will remain not to treat dilapidation payments as further consideration for the supply of a lease. However, HMRC explicitly reserve the right to depart from that view if in individual cases there is evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.

The guidance deals mostly with contractually agreed provisions for compensation. The VAT treatment of a payment of damages for breach of contract would still depend on the proper analysis of what that payment was for. Simple compensation for economic loss or payment for a supply that has taken place, for example. However, the new guidance also deals with contracts that allow early termination if a particular event occurs (such as the customer breaching the terms) on payment of a fee by the customer. The revised guidance now takes the view, as with other payments envisaged under a contract, that if the supplier charges a fee to cover the costs of making the supply, or an additional fee broadly equivalent to what would have been charged under the contract had it run as envisaged, then the payment is further consideration for the supply.

Comment

The original HMRC guidance was clearly incorrect and needed to be rectified in the light of the recent ECJ cases. However, R&C Brief 12 (2020) took too simplistic an approach in assuming that all such payments would be subject to VAT. In practice, a much more careful analysis is necessary on a case by case basis 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.

The revised guidance should be adopted by businesses no later than 1 April 2022. Since R&C Brief 12 (2020) initially required businesses to adopt the revised guidance on a retrospective footing, this is perhaps the most sensible and welcome of the changes to the guidance.