HMRC’s retrospective change on VAT and contract terminations: practical options for businesses

On 2 September 2020, HMRC published Revenue & Customs Brief 12/2020, which set out a change in the VAT treatment of payments made in respect of contract terminations and contractual disputes. HMRC’s new general rule is that most such payments will be subject to VAT instead of outside the scope as per HMRC’s previous guidance. The change in VAT treatment is as a result of two EU cases involving Portuguese telecoms providers MEO and Vodafone Portugal. Surprisingly, the brief says that the change will have retrospective effect, unless a business benefits from a specific ruling that VAT was not payable.

Businesses that received compensation payments before the brief was issued which they thought were not subject to VAT, may now find themselves with a potential VAT liability and may need to take action.

Changing guidance retrospectively

The HMRC brief provides that anyone who has not accounted for VAT on the basis of HMRC’s new practice needs to "correct the error", unless they have a specific ruling that VAT was not payable.

HMRC’s previous practice was clearly set out in the VAT Supply and Consideration Manual. However, HMRC can resile from its previous guidance if that is a proportionate response bearing in mind legitimate expectation, legal certainty and HMRC’s public duty to collect tax. EU cases, including the cases cited by HMRC as a reason for its change of practice, do not make new law, but rather clarify what the law has always been.

Retrospective application is not an approach that HMRC usually adopts when it changes its practice. However, statute gives HMRC power to issue assessments for under-declared output tax for a period of up to four years. Such a look back seems particularly harsh in these circumstances as the decision in the Vodafone case was not issued until June 2020 and the decision in the MEO case was only issued in November 2018.

What should potentially affected taxpayers do?

Businesses which have received contract termination payments or payments to settle contractual disputes over the last four years on which they have not accounted for VAT need to consider whether the circumstances mirror those in the case law developments.

Remember that HMRC’s new practice only relates to contract terminations and damages relating to contracts. Damages payments relating to other types of dispute are unaffected. The guidance envisages payments being made by the customer, so where the compensation is paid by the supplier rather than the customer, the reality may be that no supply is being made.

Businesses affected by the new guidance should seek advice on their own particular circumstances. However, many businesses will fall into one of two broad groups:

• Those whose factual position is fully aligned with that of MEO or Vodafone such that the principles established in those cases clearly apply. These businesses should consider whether there is any potential to recover the VAT from the entity which made the payment. If that is not practicable, these businesses need to pay the VAT and accept they will be out of pocket or consider whether they can challenge HMRC’s approach by way of judicial review (JR).
• For businesses whose factual position is not fully aligned with that of MEO or Vodafone and where it is not clear whether the principles in those cases apply, it would be advisable to write to HMRC. The letter should set out reasons why it is considered that the brief does not apply to specific payments received. HMRC should issue a decision which either accepts or rejects this view. A decision that VAT is due creates two potential routes to remedy: first, a challenge in the First-tier Tribunal (FTT) on whether HMRC’s view of the VAT treatment is correct; and, secondly, a possible challenge before the Administrative Court – a specialist division of the High Court of England and Wales – by way of JR against the brief’s retrospective application.

Routes to remedy

The applicable time limit for bringing an appeal to the FTT to challenge the VAT treatment does not start to run until HMRC issues a decision specific to a particular business. The grounds for such an appeal will be entirely dependent on the factual circumstances surrounding the payment.

An application for JR must be filed "promptly" and in any event not later than three months after the grounds to make the claim first arose. If a business’s factual position falls within the remit of the MEO or Vodafone case, so that the brief applies, the time for bringing a challenge by way of JR will start to run from 2 September 2020. If, however, the business’s circumstances are distinguishable from those cases, then it is arguable that the time for bringing a JR claim will not start to run until the business receives a decision from HMRC that the payment is subject to VAT.

To challenge the retrospective application, the most applicable ground for JR is to challenge whether HMRC is responsible for breaching a business’s legitimate expectation that it could rely on HMRC’s guidance, as it was applied at the time, that the payment would not be subject to VAT and that it would be an unjust exercise of power for HMRC to frustrate that expectation by resiling from its guidance.

For a business in circumstances where both routes to remedy are available, it may be worthwhile considering issuing a ‘protective’ JR and having those proceedings halted while they await the outcome of an FTT appeal. If a business is successful before the FTT, then the JR can be withdrawn. If a business is unsuccessful before the FTT on the correct VAT treatment, there is still the opportunity to challenge HMRC’s retrospective application of the brief.

JR claims can be costly as the work is largely front-loaded. If bringing a claim on an individual basis would not be warranted, given the tax at stake versus the costs, there may be scope to bring a group action so the costs can be shared.

Unless HMRC has a change of heart and makes the change prospective only, potentially affected businesses should review past payments that might fall within the terms of the brief to assess whether they should be taking any action to protect their position in respect of JR. For many, time is already running out to bring a claim.

This is based on an article by Clara Boyd, a VAT disputes expert at Pinsent Masons, the law firm behind Out-Law, which appeared in Tax Journal on 6 November 2020.