VAT on Termination Charges – Where are we now?

09 November 2020

Following recent judgements in the European Court of Justice, HMRC published a Business Brief (12/2020) in September, asserting that: “most early termination and cancellation fees are ….liable for VAT. This is the case even if they are described as compensation or damages.”

HMRC’s controversial U-turn on the VAT treatment of Termination Charges will have wide reaching consequences. Whilst it still requires clarification on what the Department means by ‘termination and cancellation fees’; HMRC confirm they expect this new policy to be applied retrospectively, which could impact payments made over the past four years.

This change in interpretation will be of particular concern for law firms and those involved in the property and construction sector as previously, termination payments charged on the withdrawal of an agreement to receive goods or services were widely believed to be outside the scope of VAT. Historic contracts may now appear deficient and doubt arises on wording of future agreements.

Areas of doubt or change:

Deposits: At the time a deposit is received it is treated as part payment for the intended supply and therefore adopts the same VAT liability. Is there a risk that HMRC will reclassify surrendered deposits as being consideration for the right to walk away from a contract i.e. a VATable right even if the initial intention was to buy a VAT exempt or zero-rated property?

Dilapidations: These are often payable at termination, but does this bring them within the scope of HMRC’s VATable ‘termination fees’? Perhaps they become regarded as additional consideration for the supply of the property and subject to the same VAT treatment as the lease. Even if an outgoing tenant carries out repairs in lieu of dilapidations, HMRC might regard this as consideration in kind, so will not necessarily absolve a landlord from a VAT liability.

Lease “break payments”, or early termination payments: whether specified in the lease or negotiated separately between the landlord and the tenant (where the option to tax has been applied), may now be liable for VAT.

Payments for breach of contract: previously treated as compensation for loss of profit or loss of income, rather than for a supply, and therefore previously outside the scope of VAT, may now be liable.

Contractual Terms

Whilst there is ongoing uncertainty, HMRC’s policy change needs to be reflected in contractual terms from 2nd September 2020 onward, so that the contract protects the supplier by stating that any consideration is exclusive of VAT where it due to: termination; exercise of break clauses; or dilapidations. There must be an emphasis on ‘consideration’ rather than purely ‘monetary consideration’ to cover the possibility of settlement in kind.

Historic Position

Although HMRC acknowledge their previous guidance advised such fees were outside the scope of VAT, they expect this new policy to be applied retrospectively; unless a business has had a specific ruling from HMRC stating that such fees are outside the scope of VAT (in which case the change should be applied from 2nd September 2020).  

HMRC have been heavily criticised about this threat of retrospective action and, at least temporarily, have instructed their officers not to enforce the policy historically whilst they reconsider their position. However, even if they relent and only apply their views from the date of the Policy Brief, this still creates a risk of loss to landlords and other suppliers when termination arises and contracts did not envisage the possibility of a VAT charge.

The Customer’s Position

Where a contract is silent about the application of VAT, sums are usually considered to be inclusive of any VAT which is due.

This may create an opportunity for VAT registered customers to seek VAT recovery on termination payments, even though both parties previously considered those payments to be outside the scope of VAT. This may be an aspect of retrospection which HMRC have not bargained for.

Conclusion

The guidance is clear in terms of termination fees, but for compensation payments, it is important to analyse the position from a VAT perspective. The legal terminology may refer to a payment as ‘compensation’, but to determine whether the payment is subject to VAT, consideration should be given to the nature of the payment and if anything is received in return. Genuine compensation, for which nothing is received should remain outside the scope of VAT.  

Hopefully, HMRC will publish a more detailed and reasoned policy in due course. In the meantime, suppliers should insist on protective VAT clauses in all supply contracts.

Find out more 

If you would like to discuss more about how this decision will impact your business going forward, please contact our VAT Director, Glyn Edwards on:

T: +44 (0)7889 537549
E: glyn.edwards@mhllp.co.uk 

or alternatively complete our online enquiry form.

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