The next step

Guidance on the change of policy

[Weblink]

HMRC confirms new policy is retrospective

Change in practice

HMRC has issued a Brief stating its new policy that early termination fees and compensation payments that relate to contracts are now subject to VAT. The previous policy was that they were outside the scope of VAT because they did not relate to a specific supply of goods or services.

This issue is important for both suppliers and customers. A VAT charge will not be claimable as input tax for a business that makes exempt supplies or is partially exempt. Suppliers could be faced with a hefty assessment for VAT owed on past supplies.

Example. John trades as an insurance broker and is not satisfied with the services provided by the office cleaners at his business premises. He 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 John because his insurance business is partially exempt and cannot fully claim input tax on its overheads.

Trap. The Brief also 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 specified by a clause in an existing contract.

European Court tribunal cases

HMRC’s policy has changed because it has considered the outcome of two VAT tribunal cases heard in the Court of Justice of the European Union (CJEU). Both cases related to assessments raised by the Portuguese tax authorities in relation to fees charged by mobile phone suppliers for the early termination of contracts. The CJEU decided that the payments were directly linked to a supply of services from the mobile phone company to the customer and were therefore subject to VAT.

Tip. If your business provides services where early termination fees and compensation payments are earned, you need to review the VAT position urgently. HMRC has issued new guidance about the policy change (see The next step ).

Retrospective change

Unfortunately, there is more bad news. Unless your business received a written ruling from HMRC confirming that termination fees and compensation payments are not subject to VAT, you will need to adjust past errors for the last four years, i.e. where output tax has been understated. This is very harsh because HMRC’s 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 completely removed from the manuals.

Tip. If your business received a written ruling from HMRC, the correct VAT treatment only needs to be applied on supplies you make after the date of the brief, i.e. from 2 September 2020. A telephone ruling should be acceptable, as long as you recorded the call and noted the call reference number from the officer who gave you the decision.

For a link to the guidance on the change of policy, visit https://www.tips-and-advice.co.uk , Download Zone, year 10, issue 11.