In early September 2020, HMRC updated its guidance on the VAT treatment of early termination fees, compensation payments and liquidated damages following recent decisions of the Court of Justice of the European Union (“CJEU”).

Whether a payment is a supply for VAT purposes depends on whether anything is done in return for that payment; where a party agrees to do something in return for the payment there is a supply for VAT purposes.  Until the recent update, HMRC considered that payments that were compensatory in nature were outside the scope of VAT (as there was no supply for VAT purposes). HMRC’s approach was based on the CJEU decision in Société Thermale d’Eugénie-Les-Bains (C-277/05) which related to the VAT treatment of forfeit deposits for no-show hotel bookings.  HMRC’s (now removed) guidance stated that, in respect of termination fees,:

There is no supply for VAT purposes of “the right to terminate” or other such service where a contract originally contains a clause allowing the parties to terminate early in lieu of compensation for perceived losses arising from the termination. However, there will be supplies where no such right exists and agreements have separately to be reached properly to terminate the contracts. This is so even if there is much talk of monetary ‘compensation’ in these agreements.”

This position was applied by HMRC in other similar areas such as liquidated damages and payments for early termination of contracts.

However, following the recent decisions of the CJEU in Vodafone Portugal (Case C-43/19) and the decision in Meo (C-295/17), HMRC’s guidance now provides that early termination fees, compensation payments and liquidated damages may be subject to  VAT.  It is irrelevant whether the payment is described as compensation or damages; it is irrelevant whether the contract contains a right to terminate. Whether the payment is subject to VAT is a question of fact: is there a direct link between the payment and a supply of goods or services? If so, the payment will be subject to VAT; if not the payment will be outside the scope of VAT.  In its updated guidance HMRC uses the facts of the CJEU decision in Mohr v Finanzamt Bad Segeberg (C-215/94) (concerning payments made by state authorities to farmers to cease milk production) as an example of a compensatory payment that should be treated as outside the scope of VAT. Of course, the facts of that case were somewhat niche and not the ordinary fact pattern where compensatory payments are made! In short, it seems that HMRC’s view is that a payment will only be outside the scope of VAT if it is purely compensatory; if the recipient does anything in return for the payment then it will be a supply for VAT purposes.

HMRC states in its updated guidance that, based on those CJEU decisions,:

  • early contract termination payments are consideration for a taxable supply whether the original contract allows for such a termination, a separate agreement is reached or there is no pre-existing right to terminate the original contract. For these purposes it is irrelevant whether the customer is no longer making use of the original supply.
  • early upgrade payments are a form of early termination fee and should be treated in the same way for VAT purposes.
  • although liquidated damages payments are designed to compensate, they are made as a result of events envisaged under the contract and, accordingly, are part of the consideration and consideration for what is provided under it.
  • payments made on contractual termination following breach of contract by one of the parties should be treated in the same way as other payments envisaged under the contract.

Unfortunately the guidance raises a number of (unanswered) questions creating unwelcome uncertainty for taxpayers. For instance, in an M&A context the VAT treatment of break fees is unclear given the payment flows (break fees would generally flow in the opposite direction to payment of consideration); equally, it is unclear whether the VAT treatment of the payment should follow the VAT treatment of the original supply (which will be relevant if the original supply was not a fully taxable supply for VAT purposes).

However, perhaps most unwelcome of all is the retrospective nature of this change. Generally, where HMRC makes changes to its guidance such changes do not have retrospective effect. Unfortunately, that is not the case with respect to this update. Instead, HMRC notes that any taxpayer that has failed to account for VAT to HMRC on such payments should correct such error (unless the taxpayer had a written ruling from HMRC). That requires a four year look back and may result in companies that received such payments four years ago having to account to HMRC for VAT on that payment.  Changing policy in such a way, with retrospective effect and without stakeholder consultation, is controversial. However, taxpayers should assess whether they have received such payments over the last four years and if they now need to account to HMRC for VAT in respect of that payment.