Until recently, HM Revenues & Customs (HMRC) typically took the view that as compensation or damages payments were not consideration for a supply, they were outside the scope of Value Added Tax (VAT). Following two recent EU judgements, HMRC has now reversed this position, so that many compensation payments or early termination fees will now fall within the VAT regime.
HMRC has updated its position as set out in (Revenue and Customs Brief 12 (dated 2 September 2020)(the Brief):
- Liquidated damages – payments made under contractual obligation to compensate the other party on the early termination of a contract are now considered within the scope of VAT. HMRC’s reasoning provides that the circumstances for terminating are as a result of events as envisioned when entering into the contract forming part of the agreement and are therefore consideration for the supply of the goods or services. Further guidance can be found at VATSC05930.
- Payments for a breach of contract – contracts which terminate on specific events, such as a breach of contract, and provide for a compensatory termination fee from the party responsible for the breach is a further event envisioned by the contract. Payments made under such contract terms are treated as consideration for a supply and so are chargeable to VAT. Further guidance can be found at VATSC05930.
Overall, HMRC have stated that early termination fees will now be considered “as generally liable for VAT”, even in cases where the payments are “described as compensation or damages”. The result of this changing approach by HMRC will mean that most compensation, early termination and cancellation fees will now be considered as payments for a supply, and so will be now liable for VAT.
This change may also have a significant retrospective impact as well. In the Brief, HMRC indicated that anyone who has not accounted for VAT on the above such payments should correct this error. Furthermore, VAT will be payable on any amounts received after the date of this brief, even where HMRC previously ruled that such payments were outside the scope of VAT. The extent to which HMRC will take retrospective action remains to be seen, but taxpayers should be aware of the potential risks they face should they fail to correct any such error.