Compensating for past errors – HMRC’s retrospective change in approach to VAT on compensation
Last month HMRC announced in a Business Brief (12/20) a change in its view of the VAT treatment of certain compensation payments relating to the termination of contracts pursuant to recent case law at EU level. Previously, HMRC’s view of the law was generally that compensation payments paid on the termination of an agreement were outside the scope of VAT.
The new guidance – which updates HMRC’s Manual – makes it clear that certain payments made on the termination of contracts, which previously would have been viewed as compensation, should instead be subject to VAT. In addition, the new guidance can be read as applying more broadly and at face value applies to many types of compensation payments and damages. Clarification is being sought from HMRC as to whether the changes are actually intended to be that broad, and we understand that HMRC is reviewing the guidance to consider its scope. It is not clear that the change should be applied broadly as the case law giving rise to the change in approach by HMRC seems to apply more narrowly. We comment further on certain types of payment below. Most unfortunately of all, HMRC is of the view that taxpayers are required to apply this change of practice retrospectively, meaning that payments under contracts made in the past must now be revisited (subject to the general VAT time limits for correcting past errors, which in practice should mean four years). Until HMRC has completed its review of the scope of the new guidance, we do not expect HMRC to be proactive in applying the changes. Taxpayers are not required to do this if a specific ruling was obtained from HMRC in relation to a particular payment, but this is unlikely to be relevant to many taxpayers.
The full guidance is set out in Revenue and Customs Brief 12 (2020) and in updates to the VAT Manuals (VATSC05900 to VATSC05930).
As noted above, HMRC will apply the new approach to most payments that have been made in the past and all new payments made in future. As a result taxpayers should review payments that they have received from customers that have been treated as compensation, and consider whether VAT should be accounted for on these sums. If the original VAT treatment was incorrect (under HMRC’s new view), the supplier should pay the output VAT due to HMRC and amend their VAT returns. At that point, it will be essential to consider the contractual arrangements to determine whether the cost can be passed on to the recipient of the supply.
The wording of the guidance is such that HMRC appear to say that all termination payments are subject to VAT even if the main supply is exempt (say, in relation to a lease where the landlord had not opted to tax). This does not seem likely to be correct, as the underlying analysis in the case law is that the termination payment is a further payment for the main supply, and so it must take the same VAT treatment.
The obligation to look back over past payments and transactions applies to the period to 2 September 2020. Clearly, for many businesses reviewing four years’ worth of transactions will be an onerous obligation. All payments made on or after 2 September 2020 are also caught.
Recipients of supplies (customers, tenants etc) will of course also be affected by these changes. If an amount of compensation has been paid, the supplier may seek to issue a VAT invoice and request that the amount equal to VAT is paid. This may be a cash flow cost only for the payer, but it would be an absolute cost to any VAT exempt businesses. Before making any additional payments or considering if VAT recovery if possible, recipients of supplies should check that the VAT is properly charged. This would include checking the new guidance, taking a view on any grey areas and confirming the contractual position.
Given that HMRC is reviewing the scope of the new guidance, suppliers and recipients of supplies may choose to wait for clarification from HMRC before making payments (either to HMRC or suppliers) or amending their VAT accounts. However, businesses would be well advised to review termination and compensation payments to understand the extent of any potential payments and changes to VAT accounts that may be required. This will allow businesses to act promptly once HMRC’s views are clarified.
Specific types of payment
If VAT would be payable in respect of the supplies made under the contract, a payment made by the customer to bring the contract to an end early is now subject to VAT. HMRC’s guidance gives the example from the case of Vodafone Portugal C - 43/19 of payments made to end a mobile phone contract before the end of the contractual period. This would also apply to payments to terminate agreements for the supply of other goods or services, such as the payment of a break fee to end a lease.
HMRC will treat payments made to upgrade the goods or services supplied as a termination of the original agreement, and so VAT may be payable on the upgrade fee.
Liquidated damages and payments for loss of earnings
Agreements often include provisions setting out the amounts payable if the agreement is terminated early which are expressed to be payments of liquidated damages, being a measure of the loss and costs that the supplier would incur as a result of the termination. Under HMRC’s guidance, VAT is now due on these payments where VAT is due on the consideration for the supply under the agreement. However, VAT should not be due on payments of compensation made by the supplier to their customer.
Contracts for construction services can include similar obligations. If a contract for construction services is terminated, payments of liquidated damages and payments for delay may be due. If the employer makes payment to the contractor to compensate them for wasted time or costs (and this payment was envisaged by the contract) VAT would be chargeable at the same rate as the main supply. However, if the contractor makes payments to the employer, this payment should not have a direct link to the supply of the construction services, and should remain outside the scope of VAT.
Breach of contract leading to termination
If there is a breach of contract, and this brings the agreement to an end, payments may be due in respect of the termination. VAT is now due on these payments where they are made to the supplier and VAT was due on the original supply of goods or services. HMRC give the example of a lease automatically terminating due to the insolvency of the tenant or another company connected to the tenant. Payments made by the tenant to the landlord on the breach and consequential termination would be subject to VAT if the landlord had opted to tax.
Dilapidations and other compensatory payments
Another common payment due on termination of a lease is in respect of dilapidations, which have always been treated as outside the scope of VAT on the basis that they are compensatory payments for breach of contract.
HMRC’s guidance is so widely cast that it is possible to interpret it as requiring VAT to be charged on these types of compensatory payments, but as noted above it seems at odds with the underlying case law and it is hoped that HMRC will soon clarify the scope of the change by amending the guidance.
In the meantime, contact us for specialist advice if you may be affected by this change.
For more information, please contact Helen Coward on +44 (0)20 7427 6766 or at email@example.com or your usual Charles Russell Speechlys contact.