VAT - 22.10.2020

Early termination and compensation fees: new policy

New interpretation

Until very recently, HMRC’s published view was that early termination fees and compensation payments that relate to contracts were outside the scope of VAT because they did not relate to a specific supply of goods or services. However, this changed on 2 September 2020 with the publication of Revenue & Customs Brief 12 (2020) (see Follow up ).

The Brief explained that HMRC now expects that such fees will be subject to VAT in most cases. This issue is important for both suppliers and customers.

A VAT charge will not be claimable as input tax by a business that makes exempt supplies, is partially exempt, or uses the flat rate scheme. Suppliers receiving compensation fees could be faced with a large assessment for VAT owed on past supplies, as the policy change is retrospective.

Pro advice. Don’t forget that VAT is a tax on the supply of goods or services. This is always the first question you should ask when considering if a source of income earned by your clients could be liable to VAT. If there is no supply of goods or services, there can be no VAT to pay. HMRC now considers that compensation payments and termination fees that directly relate to contracts are relevant to supplies made in that contract.

Example. Mary trades as an insurance broker and is dissatisfied with the services provided by the office cleaners at her premises. She has decided to cancel the contract but must pay a termination fee equal to six months of cleaning fees to the supplier. HMRC now regards the charge by the cleaners as being subject to VAT, even though no cleaning work will be done in return for this payment. This will be an extra cost to Mary because her insurance business is partially exempt and cannot fully claim input tax.

Pro advice. The Brief states that fees will still be subject to VAT even if the payment is agreed by the two parties through a separate agreement, i.e. it is not relevant to a specific clause in an existing contract.

CJEU tribunal cases

HMRC’s policy has changed because it has reviewed the outcome of two VAT tribunal cases heard in the Court of Justice of the European Union (CJEU) and decided its own interpretation of the legislation was incorrect.

The first case related to payments made by customers with mobile telephone contracts, who had to make a one-off payment to their supplier (M) to exit a contract early. The charge was reasonable because the customer had received a discount on the deal because of the extended period of the contract.

The Portuguese tax authorities assessed M for output tax on the payments, but M claimed they didn’t relate to any actual supply of services and should not be subject to VAT. The CJEU agreed with the tax authority that the payments related to remuneration for a supply of services. The mention of the payment being a “penalty” for early termination was irrelevant.

Amount paid not relevant

The second case was similar but in the first the customer had to make a full compensation payment to cancel their mobile phone contract, i.e. paying the same amount of money as if the contract had continued until it expired. In the second case, there was a specific formula used to determine how much compensation the customer needed to pay. This would be less than the full contract value. But the VAT outcome was the same: the remuneration received by both companies directly related to a taxable mobile phone contract and VAT was therefore payable on the cancellation fees.

Pro advice. If your clients provide any services where early termination fees and compensation payments are earned, it must review the VAT position urgently. HMRC has issued new guidance about the changes (see Follow up ).

Retrospective change

HMRC has confirmed that the change in policy is retrospective. The exception is if a business has received a past ruling from HMRC confirming that its termination fees and compensation payments are not subject to VAT. In such cases, the revised policy must be applied from the date of the Brief, 2 September 2020.

Your clients must adjust errors for the last four years where output tax has been understated, using the usual VAT correction procedures set out in VAT Notice 700/45 (see Follow up ). This is unexpected because HMRC’s own manuals previously stated that these payments were outside the scope of VAT. But the manuals are not VAT law and HMRC says that it must apply the law correctly. The previous incorrect guidance has been removed from the manuals.

Pro advice. A telephone ruling from HMRC should be acceptable as evidence of a past ruling, as long as you or your clients kept the call reference number. Even if you do not have a call reference number, it is likely that HMRC will be able to find details of the call on its system via your client’s VAT registration number.

Exempt, FRS

The issue of termination fees and compensation payments is not only important for any clients who must decide if they should charge VAT on the fees they have received in the past and will receive in the future.

It is also important for clients who have cancelled or terminated contracts but cannot fully claim input tax on their expenses, i.e. their business is exempt or partially exempt or uses the flat rate scheme. The VAT charged by the supplier whose contract has been cancelled will be an extra cost to your client’s business.

Even if your clients can claim input tax because their business is fully taxable, it is always important to check if VAT charged by a supplier is correct. Input tax cannot be claimed on incorrectly charged VAT.

Pro advice. If a supplier of any goods or services has incorrectly charged VAT, the remedy is to get a VAT credit from the supplier and not claim input tax. The fact that you have been given a VAT invoice by the supplier and paid VAT to them is irrelevant.

Descriptions no longer key

In the past, a question about the VAT liability of a source of income would be influenced by the use of words in contracts and on invoices such as “cancellation fee”, “termination payment”, “penalty for ending contract early”. However, this approach can no longer be adopted. The new guidance states “Whether a payment is for a VAT supply depends on whether anything is done in return for consideration. Where a party agrees to do something in return for a fee there is a supply. How that fee is described does not affect whether there is a supply for VAT“. It is also not relevant whether the charge is provided for in the contract, or negotiated separately.

Other situations

Despite the radical change of policy by HMRC, there will still be some compensation payments that will be outside the scope of VAT. For example, penalties and fines that are charged as a result of customer behaviour will still be VAT free in most cases.

Example. Seaside Guest House has a policy that if a guest smokes in their room, the hotel will apply a cleaning charge of £100. This is a compensation payment to the hotel for the extra cleaning costs caused by the guest’s misdemeanour. There is no supply of goods or services by the hotel to the guest and the payment will be outside the scope of VAT.

Pro advice. In this situation, there is no termination fee or compensation payment that directly relates to a contract for services between the two parties. This is a useful issue to consider when reviewing the VAT liability of income received by your clients.

Follow up   https://www.tips-and-advice.co.uk , Download Zone, yr.7, iss.6