VAT and the Late Payment of Commercial Debts (Interest) Act 1998: VAT payable on the contract price is subject to enhanced interest along with the underlying debt

In recent case of Pharos Offshore Group Limited v Keynvor Morlift Limited, the judge decided that where the contract requires the payer to pay the contract price and that price is subject to and inclusive of VAT, then enhanced interest under the Late Payment of Commercial Debts (Interest) Act 1998 accrues on the VAT element as well as the debt for the unpaid contract price. 

In this article we look at the reasons given for this decision and explain how this affects parties to a contract for taxable supplies.

When is VAT a ‘qualifying debt’?

Keynvor, a marine contractor, was employed to lay a high voltage cable between the United Kingdom and Denmark. As part of that project, Keynvor entered into a contract with Pharos for the supply of subsea equipment, specialist personnel and engineering services. A dispute arose under the contract. Pharos claimed the balance of unpaid sums due under invoices it had issued to Keynvor. Keynvor relied upon a set off, alleging a supply failure by Pharos. In the first action between the parties, the judge found a balance was due from Keynvor to Pharos. 

A further dispute arose between these parties including an issue about whether enhanced interest was payable on the VAT element of the judgment under Late Payment of Commercial Debts (Interest) Act. Keynvor’s position was that the enhanced interest only accrued on the underlying contract price debt, and not the VAT that was due in respect of it. Pharos took the opposite position, and the court was asked to decide who was right.

The starting point is section 3(1) of the Act: 

Keynvor’s first argument, which it described as a ‘statement of the obvious’, was that VAT is not a part of the contract price and therefore could not be a ‘qualifying debt’ under section 3(1). That section, it said, is only concerned with the ‘contract price’. Keynvor pointed out that clause 6.1 of the parties’ contract defined the contract price as a ‘fixed and firm’ sum that was ‘exclusive of VAT’. The judge rejected that argument. He noted that purchase orders issued by Pharos included VAT, and on a proper interpretation of the contract, but also as a matter of tax law, the contract price was clearly inclusive of VAT. Pharos was registered for VAT and was required to charge VAT and Keynvor was required to pay it. 

The fact the contract price was described as the net sum ‘exclusive of VAT’ did not mean that liability to pay enhanced interest on the VAT due on the qualifying debt under the Act was also excluded. It followed that the VAT was an element of the contract price and was therefore part of the 'qualifying debt' for the purposes of section 3(1) the Act. 

Another argument raised by Keynvor as to why VAT should not be treated as part of the ‘contract price’ and therefore not a ‘qualifying debt’ under section 3(1) was that interest under the Act would significantly increase the amount of enhanced interest due from Keynvor, which would give Pharos an ‘unwarranted windfall’. The interest on the VAT element would not be accounted for as either input or output tax. 

The judge agreed that the effect of deciding that VAT on the contract price was part of the qualifying debt was that the recipient would receive a sum in excess of its actual losses, and accepted that the windfall could be significant, particularly if the creditor was accounting for VAT on a cash basis, but said that was the intended effect of the Act. The enhanced interest was there to discourage late payment of commercial debts, and ‘the fact that the recovery by the recipient under the Act is in a sum in excess of purely compensatory interest’ was part of the Act’s punitive function.

What does this mean for late payment of vatable supplies?

In a decision which may come as a surprise to some, the court has confirmed that, in contracts for the supply of goods and services where VAT must be charged as part of the contract sum, the default position is that the VAT element is treated as part of ‘qualifying debt’ for the purposes of the Act. Section 3(1) applies where the obligation to pay the contract price under the contract gives rise to the obligation to pay the applicable VAT. The underlying sum and the VAT are together the contract sum and form the qualifying debt.  

With the position now clarified, a debtor who is party to a contract for taxable supplies can expect enhanced interest to be claimed on the unpaid principal sum plus VAT, which could result in a significant increase in the amount owed. The Act punishes late payment of commercial debts, and treating VAT element as part of the qualifying debt, however harsh, is part of that regime.

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