Hydeam Sulton Tax Partner - Head of VAT and Indirect Tax at Armstrong Watson explores the impact on the legal sector of HMRC’s change of policy on compensation and early termination payments.
Lord Justice Sedley famously described the world of VAT as a kind of fiscal theme park in which factual and legal realities are suspended or inverted. With HMRC’s policy change on compensation and early termination payments this statement has seldom been truer in relation to the definition of ‘consideration’ for a supply.
For many lawyers, VAT is often a minefield at the best of times and HMRC’s latest policy change makes the waters now even muddier. Scenarios where payments pass between parties which would historically have been outside the scope of VAT are now viewed by HMRC as within the scope of VAT as consideration for a supply. This is despite the fact that from a non-VAT law perspective, they would not generally be thought of as consideration for a supply contractually.
The changes will impact lawyers working across a broad range of practice areas including commercial, real estate and litigation.
It is essential that the changes in HMRC policy are understood when advising clients and drafting contracts, as the world of VAT has expanded (or at least it has in the eyes of HMRC).
The updated guidance issued in February 2022 has sought to provide long awaited clarity following the fallout from the issue of Revenue and Customs Brief 12 (2020): VAT early termination fees and compensation payments (‘RCB 12/20’). RCB 12/20 announced at the time a significant HMRC policy departure from treating compensation and early termination fees in a contract as generally outside the scope of VAT to generally within the scope VAT.
Background
HMRC’s policy change followed judgements of the Court of Justice of the European Union (‘CJEU’) in MEO C‑295/17 (‘MEO’) and Vodafone Portugal C‑43/19 (Vodafone Portugal’) and related to early termination of mobile phone contracts. The CJEU held:
MEO
If a supplier receives a predetermined amount where a contract for the supply of services has a minimum commitment period that is terminated early by its customer (or for a reason attributable to the customer) which corresponds to the amount that would have been received in the absence of such termination, this must be regarded as remuneration for a supply of services for consideration and subject to VAT if taxable.
The following are not decisive for classifying the amount predetermined in the services contract which the customer is liable to pay in the event of early termination:
The objective to discourage customers from not observing the minimum commitment period and to make good the damage that the operator suffers in the event of failure to observe that period.
Whether the remuneration received by a commercial agent for the conclusion of contracts stipulating a minimum period of commitment is higher than that provided for under contracts which do not stipulate such a period.
That the amount invoiced is classified under national law as a penalty.
Vodafone Portugal
Amounts received in the event of early termination, for reasons specific to the customer, of a services contract requiring compliance with a tie-in period in exchange for granting that customer advantageous commercial conditions, must be considered to constitute the remuneration for a supply of services for consideration and subject to VAT if taxable.
Whilst the CJEU’s findings were based on the specific facts in MEO and Vodafone Portugal and arguably had limited wider application given the specific arrangements entered into in these cases, HMRC unexpectedly went significantly further in RCB/20 and overnight changed the default VAT treatment of what has always generally been considered outside the scope receipts to consideration, including with retrospective application.
Inevitably, HMRC’s policy change was met with significant pushback due to the one size fits all approach which led HMRC to announce a moratorium in January 2021 until HMRC’s revised guidance was published. HMRC did however helpfully provide confirmation there would be no retrospective application of the change.
The revised guidance was eventually released in the form of RCB 02/22 and the updated internal staff VAT manuals.
HMRC’s latest approach following RCB 02/22
Unfortunately, despite some limited noted exceptions, HMRC has broadly maintained its position that the starting point for compensation and early payments is that they are consideration for a supply.
Key points for HMRC guidance
It is HMRC’s view that:
Whether a payment is called compensation/damages is not determinative. What is important is whether something is done and if there is a direct link between what is done and the payment received, and reciprocity between the supplier and the customer.
Where a supplier makes a supply available to a customer, but they do not avail themselves of all or part of that supply, and the supplier charges a payment to compensate them for having made the supply available that will normally be further consideration for that supply.
Where fees are at a level such that they are clearly punitive and designed to prevent breach rather than to compensate for lost income, then the link between that payment and the supply is not sufficient to regard it as additional consideration, and it will be outside the scope of VAT.
Where a contract ends as a result of an action by the customer which causes the supplier to terminate a lease, then if the supplier charges a fee to cover the costs of making the supply, or an additional fee broadly equivalent to what would have been charged under the lease had it run as envisaged, then the payment is further consideration for the supply.
Where a supplier breaches the terms of a contract, rather than the customer doing so, then they may reduce the price they charge for the supply, as what is being supplied has been altered. This will result in less VAT being charged if the supply is taxable. If the adjustment is made retrospectively the supplier must adjust the VAT they have accounted for under VAT Regulation 38.
Payments arising out of early contract termination will normally be further consideration for the contracted supply where the payments are linked to that supply.
Although liquidated damages payments are partly designed to compensate, they are made as a result of events provided for under the contract and are therefore part of the agreement, and if they form costs to the supplier of making the supply available or equate to what would have been charged for the supply had it run as expected they may be further consideration for the supply.
Specific examples in HMRC guidance
HMRC guidance does contain a number of clarifications and examples which are helpful and arguably have wider application in determining HMRC’s overall approach to whether payments are subject to VAT. However, caution is recommended in applying any of the HMRC examples more widely as these will likely be viewed by HMRC officers as an ‘exception list’ not an aide to interpretation.
Dilapidation payments:
Dilapidation payments are not further consideration for the supply of a lease, but HMRC might depart from that view if in individual cases it found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.
Hire of Goods:
A charge for late return of a hire car will normally be subject to VAT as it is made for the supply of the car, and the customer is aware that an additional charge will be made and how much that charge will be or how the charge will be calculated.
A charge in the event a customer writes off a hire car would not normally be subject to VAT as the supplier does not agree that the customer can write the car off, and this is not something one would normally expect as part of the supply and therefore as the necessary reciprocity does not exist.
Lease agreements movable goods:
Lease agreements for moveable goods where customers can cancel after an initial period of hire but, if so doing, must pay a termination fee to cover the loss of future rents payments are taxable.
Car Parking:
If the fee is for the additional use of the parking space it is further consideration for the supply of parking.
Where a fine is substantial and punitive and is designed to deter a breach of the terms and conditions of parking it will be outside the scope of VAT.
Summary
Whilst HMRC’s latest guidance is welcome in terms of setting out HMRC’s approach and importantly pulling back in some key areas from the position in RCB 12/20, it is not expected to be the end of the matter as HMRC position is generally too widely drawn and it is anticipated (including by HMRC) that this area will very likely be subject to ongoing litigation.
Two notable cases have already cast further doubt on HMRC’s guidance.
The findings of the CJEU in Apcoa Parking Danmark C-90/20 raises question on the treatment of parking fines as outside the scope, but given HMRC will have had the benefits of seeing the decision before publication of its own guidance it is hoped HMRC will not revise its guidance again to bring parking fines within the scope of VAT.
Although not a VAT case, the Outer House of the Court of Session in Ventgrove Ltd v Kuehne + Nagel Ltd ([2021] CSOH 129), found MEO and Vodafone Portugal not to be directly in point in relation to a lease break payment.
Action to take
When advising clients, review payments that may flow between parties, particularly those that would not ordinarily be viewed contractually as ‘consideration’, as to whether these could fall within the scope of HMRC’s new guidance and potentially be subject to VAT.
Standard contractual documents/templates should be reviewed to ensure that the risk from HMRC’s updated guidance are clearly covered, including for example the ability to charge VAT on payments which would previously have been outside the scope of VAT.
Where VAT has been charged/not charged on compensation and early termination payments during the moratorium period, consideration should be given to how to deal with any wind back e.g. on dilapidation payments where VAT has been charged.
Specialist advice should be taken where compensation and early termination amounts are not clearly and specifically covered in HMRC’s guidance. If you would like to discuss any of the above, please speak to one of our Legal Sector experts on 0808 144 5575
