VAT – early termination of contracts and compensation payments

Published by Colin Laidlaw on 10 September 2020

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HMRC has issued Revenue & Customs Brief 12 (2020) in relation to the VAT treatment of contract termination payments, whether for early settlement or breach, which changes its prior policy. Until this month HMRC’s guidance was that most termination and compensatory payments were outside the scope of VAT.

The key payments affected are:

  • Early contract termination payments
  • Liquidated damages
  • Termination payments due to breach of contract

HMRC has followed recent higher court decisions and has stated that these payments are consideration for a supply, in most cases being further consideration for the underlying contract. For example, a mobile phone contract is standard rated and therefore a termination payment would be the same. Liquidated damages for a new build construction project, however, could be zero rated.

The default for HMRC – and thus businesses in general – has always been to treat such payments as outside the scope of VAT and so there is now a risk that businesses will not appreciate this change and properly consider termination payments when they arise. Whilst this is a significant change by HMRC, more recent case law does seem to be following this route.

Businesses and professionals will have relied on HMRC’s prior guidance, but of concern is that HMRC has stated in the Brief that, “Any taxable person that has failed to account for VAT to HMRC on such fees should correct the error”. HMRC acknowledge that if a taxable person has received a specific ruling that particular payments are outside the scope of VAT they should only account for VAT from the date of the business brief. That suggests those that have not received such a ruling may have to correct the position retrospectively (which would mean up to 4 years ago).

Businesses may argue that their prior treatment was not incorrect, on the grounds of ‘legitimate expectation’, given HMRC’s recognition in its Brief and internal guidance that it was previously incorrect.  They will clearly need to make a decision as to action in that regard. Certainly for the future, however, businesses will need to pay careful attention to the VAT treatment in order to avoid an exposure.

We would be happy to discuss your particular circumstances should you need assistance in this matter.  Please speak to Colin Laidlaw, Rupert Moyle or another member of our VAT team here.

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