VAT - 16.03.2006

Compensation payments

Compensation and VAT

Recap. Compensation payments are outside the scope of VAT as they are not consideration for a supply. This is because the payments are usually made as a result of a court order or through an agreement between the parties involved to compensate one for loss or inconvenience.

Rule of thumb. In the event of a breach of contract, any compensation agreed between the parties is outside the scope of VAT. But when are you likely to come across this?

Right to terminate. Early termination of contracts has caused some of the greatest confusion in this area. In one case two different Tribunals came to different conclusions on exactly the same facts. However, out of this confusion some clarity has arisen. The VATman now takes the view that there is no supply for VAT purposes of the “right to terminate” or other similar services, if a contract originally contains a clause allowing the parties to terminate early in lieu of compensation for losses arising from the termination. But there will be a supply where no such rights exist and a compromise has been reached to smooth the termination of an agreement.

Look for the compensation clause. Check your agreements that allow for early termination. Look for clauses that provide a formula for payment of compensation. These payments are often for loss of earnings and are known as liquidated damages.

Warning. Where disputes (involving accusations of poor workmanship, prices charged or poor standards) are settled through the courts, any settlement paid by the customer is additional consideration for the goods or services and is subject to VAT. So you’d need to account for this VAT on your next return.

Interest. What about interest? If interest is payable under the settlement then it is viewed as compensation and outside the scope of VAT.

Trade names etc. Where disputes involve libel or unauthorised use of trade names, payments are viewed as outside the scope of VAT. However, if in addition to the compensation payment, an additional payment is made to cover future use of a patent etc. then it is taxable.

Closer to home?

Landlords and tenants. There are a number of instances where payments between landlord and tenant are treated as compensation and, therefore, outside the scope of VAT. These include “mesne profits”, which are damages for wrongful occupation of the property, and dilapidations paid to the landlord at the end of lease to rectify any damage to the property. Surrenders and variations are also complex areas, so take your own professional advice; don’t just rely on the other party to get it right.

Security deposits. For example, goods are hired and a security deposit is taken. If the goods are subsequently lost or damaged and the deposit is not refunded is VAT due on this? The good news is that it’s outside the scope of VAT. This would cover machine hire, such as, a chainsaw that is broken during its hire and the deposit withheld.

Tip. Take, say, £10 out of the deposit rather than add £11.75 (£10 plus VAT) to the hire charge on your invoice. If your customer isn’t VAT registered your hire charges will be cheaper to them.