On 7 February 2022 HMRC published its Revenue and Customs Brief 2 (2022) (RCB 2 (2022)) alongside its guidance (VATSC05910, VATSC05920, VATSC05930) on the VAT liability of early termination fees and compensation payments. The policy takes effect from 1 April 2022 and all previous guidance on VAT, early termination fees and compensation payments has been withdrawn.
Amy Allen and Stephen Goldstraw examine the effect of HMRC’s updated guidance on real estate matters.
Historically, HMRC took the view that, when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply (being compensatory in nature) and were therefore outside the scope of VAT.
In September 2020, HMRC published Revenue & Customs Brief 12 (2020) (RCB 2020). The revised guidance was published following the EU Court of Justice decisions in MEO and Vodafone Portugal, in which it was decided that there was a VAT liability on compensation payable for prematurely terminating a fixed term contract. It changed the original policy so that, where an early termination or cancellation fee is considered as being linked to a supply of goods or services (under the customer’s contract) then those charges will be subject to a VAT liability. This would be the case even if they are described in the contract as compensation or damages.
Brief 12 (2020) raised concerns from property professionals about certain payments in property transactions and also whether or not the changes applied retrospectively.
The updated guidance in RCB 2(2022) emphasises that the key to determining whether VAT is chargeable on a payment is whether that payment is directly linked to - and therefore consideration for - a supply. In doing so, it provides some clarity for payments made under certain payments in property contracts as summarised below, although some confusion still remains.
Following the RCB 2020 guidance, there was concern that dilapidations payments were brought within the scope of VAT. While setting out arguments for and against the position, HMRC guidance now confirms in RCB 2(2022) that dilapidation payments will not usually be treated as further consideration for the supply of a lease.
However, HMRC does reserve its position by indicating that: 'we might depart from that view if in individual cases we found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.'
Generally, HMRC's position is that, where an early termination payment is made, that payment constitutes further consideration for the contracted supply and is, therefore, taxable at the same rate of VAT as the supply.
HMRC states that compensation payments and liquidated damages will be subject to VAT where there is a direct link between a payment from the customer and a service provided by the supplier. For example, if a customer uses less of a supply than they contracted for and does not pay the amount agreed for the supply in the contract but instead is charged another fee to compensate the supplier for loss of earnings, this will normally be consideration for the original supply. The economic reality is the supplier has made the supply available, albeit not used.
If, however, that fee is at such a level for it to be clearly punitive (ie 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.
One of the biggest concerns was the retrospective nature of the RCB 2020 guidance. One of the most welcome clarifications from HMRC in RCB (2022) is, therefore, the confirmation that the revised guidance should be adopted by businesses no later than 1 April 2022.
In many instances there may be a fine dividing line between a charge being outside the scope of VAT and falling to be taxed at the standard rate, which could potentially have significant financial consequences.
Businesses should therefore review whether HMRC’s revised approach could be relevant to their contracts, bearing in mind that the general rule is that contract terms providing for payments - however described - linked to termination, extended use or failure to take contracted supplies will now be subject to VAT.
For a payment or part of it not to be treated as consideration, the supplier will need to evidence that it is wholly or in part punitive or otherwise clearly not attributable to the supplier’s costs or loss of earnings under the terminated contract.
In any circumstances where there is ambiguity, specialist tax advice should be sought.