Change in UK VAT treatment of contract termination and compensation payments

Previous HMRC guidance said when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT.

However, HMRC has now said that, following recent judgments of the Court of Justice of the European Union (CJEU), "it is evident that these charges are normally considered as being for the supply of goods or services for which the customer has been contracted for" and therefore should be subject to VAT.

This will mean that most early termination and cancellation fees will be liable for VAT, even if they are described as compensation or damages.

In its announcement, HMRC said that businesses that have failed to account for VAT to HMRC on such fees should correct the error. However, if they have had a specific ruling from HMRC saying that such fees are outside the scope of VAT they only need to account for VAT on fees received after 2 September 2020.

"The suggestion that the VAT treatment of past payments needs to be revisited will cause a logistical nightmare," said Eloise Walker, a tax expert at Pinsent Masons, the law firm behind Out-Law.

"HMRC couldn’t have chosen a worse time to announce a retrospective change in practice, given that the coronavirus pandemic has resulted in very many more contract terminations than usual, and litigation settling that might otherwise go to court," she said. "In relation to contract terminations, it will involve parties needing to lay their hands on 20% extra cash at the very time they haven't got it. For litigation settlements the position is even worse, as once a settlement is agreed there's just no scope commercially to ask for another 20%, whatever the contract might say. The suggestion that all this might be retrospective, is just outrageous and will rub salt into the wound."

"It's not clear how far back HMRC is expecting people to look in 'correcting' the VAT position in relation to past payments," said Clara Boyd, a tax disputes expert at Pinsent Masons.

"Although the latest decision HMRC refers to, which came in a case involving Vodafone, was issued in June 2020, the judgment in the other case mentioned, Meo, was given in November 2018. Surely HMRC cannot reasonably be expecting businesses to look this far back when they have taken so long to change their published guidance? However, the glaring absence of any timescales within HMRC's business brief will no doubt leave businesses with uncertainty as to what is required of them," she said.

"On other issues where HMRC have changed their guidance to bring it in line with recent case law authority, the tendency has been to apply the changes prospectively. It is unclear why HMRC has decided to apply these changes retrospectively. In the circumstances, the question will no doubt arise as to whether a taxpayer had a legitimate expectation that HMRC would follow their published guidance and therefore that they should not be required to revisit past treatment in accordance with that guidance," Boyd said.

"We would urge HMRC to think again and confirm that they will only apply this change in practice from the date it was announced or, preferably, a future date," she said.