Compensating for earlier mistakes: retrospective VAT changes

Kate Arnott, head of professional services, partner at MHA MacIntyre Hudson, on the HMRC confirmation that fees charged when a contract is terminated early are liable to VAT.

HMRC’s controversial U-turn on the VAT treatment of termination charges will have wide-reaching consequences, as all termination or compensation payments made under contract may now be liable for VAT – and as HMRC confirms it expects this new policy to be applied retrospectively, this could also impact payments made over the past four years.

Following recent judgements in the European Court of Justice, HMRC published a Business Brief (12/2020) in September, which confirms fees charged when a contract is terminated early are liable to VAT. The same applies to fees payable when exiting a contract to start a new one.

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 outside the scope of VAT.

For example, the new policy means that 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 (although it’s not thought to change the treatment of dilapidations). Similarly, compensation payments for breach of contract were 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, but may now be liable.

This change needs to be reflected in contractual terms from 2 September 2020 onward, so that the contract states that any fees that become payable, should the contract be terminated early, will be subject to VAT (if the goods/services supplied under the contract are VAT-able).

Although HMRC acknowledge its previous guidance advised such fees were outside the scope of VAT, and 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 2 September 2020).

The guidance is clear in terms of termination fees, but for compensation payments, it’s 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 in return remains outside the scope of VAT.

We have produced a guide to this change in policy and the potential implications for you and your clients, which you can download here.