HMRC VAT change affects payments made to terminate a contract

By Caroline Brown, Victoria Hobbs


A fundamental change to the way HMRC now applies VAT to certain types of termination payments means that payments you received without VAT under a settlement at any point in the last 4 years will need to be re-examined to check whether you (or the other party) now needs to pay VAT in respect of the payment.  We explain this important change in more detail below.


Summary of the change

  • HMRC have announced that payments made to compensate a supplier arising out of early contract termination will now in general be subject to VAT and no longer outside the scope of VAT.
  • The change will have retrospective effect for suppliers who have received termination payments in VAT accounting periods that ended within the last 4 years and have treated those payments as outside the scope of VAT in line with previous HMRC guidance.
  • This change will affect some payments in respect of settled claims for breach of contract, liquidated damages, cancellation fees, early upgrade fees and the like, regardless of whether these payments are described as compensation or damages.
  • This change will mean you may need to account for VAT on historic payments. 

What to do now?

  • If you have received a payment under a settlement agreement which was previously treated as outside the scope of VAT you will need to check whether VAT is now chargeable. 
  • If VAT is now chargeable you will need to correct the previous treatment and account for the retrospective VAT due to HMRC, in which case you should review the contract to check if it states you will be liable for the VAT cost and, if not, contact your counterparty to decide who will be liable for the VAT cost. 

For more details of this change please see below.  If you would like further advice regarding the information in this client alert please contact one of the people listed below.


What has changed?


On 2 September, HMRC published Revenue & Customs Brief 12 (2020).  This brief updates taxpayers on the UK VAT treatment of early termination fees and compensation payments following recent judgments of the Court of Justice of the European Union (CJEU) and HMRC's changes to its guidance.


The update shows a significant change in UK VAT policy particularly for businesses who have enforced minimum commitment periods against customers and/or who have charged customers pursuant to early termination fees and have treated those payments received as non-VATable.


Why has this change been made?


Historically, HMRC took the view that payments described as compensation or damages and paid by a customer for perceived losses attributable to a breach of contract, early termination event or pursuant to a liquidated damages clause, were normally outside the scope of VAT.  HMRC had relied on previous CJEU case law that these types of payments to a supplier were to compensate for loss of future earnings flowing from termination rather than being directly linked to (and not consideration for) a relevant supply. 


However, following more recent CJEU decisions on the VAT treatment of early termination fees in contracts for telecommunication services, HMRC considers that it is now clear that most payments made under these types of default provisions in contracts remain taxable consideration for supplies for which the customer has contracted for. 


HMRC will therefore now treat most compensation and similar payments made by customers arising out of early termination or cancellation as generally liable for VAT on the basis such payments should be seen as further consideration for the original supply by the recipient supplier. The fact that the customer is no longer making use of that supply is irrelevant. This treatment will apply in cases where an original contract allows for such a termination, as well as when a separate agreement is reached.


What payments are affected?


HMRC makes it clear this change will affect payments for breach of contract, liquidated damages, cancellation fees, early upgrade fees and similar payments, irrespective of whether or not any such payments are described as compensation or damages. For example, although HMRC acknowledges that liquidated damages payments are designed to compensate, its altered view is now that they are made as a result of events envisaged under the contract.  They are therefore regarded as an integral part of the agreement and remain as taxable consideration for what is provided under it.


HMRC indicates that compensation payments may only be treated as outside scope in limited circumstances where there is no direct link between a payment and a supply of goods/services by the recipient supplier. If the supplier is the defaulting party and paying a customer, the VAT treatment may also be different but the key question is whether any amount paid by the defaulting party has a direct link with a relevant supply (i.e. past or future supply of goods / services) that is subject to VAT.  What appears to be determinative is the absence of any supply to which the payment would relate.  


Importantly, HMRC’s change will have a retrospective impact - HMRC states that it is expecting taxpayers who have failed to account for VAT on such fees to correct their error – this should include payments received and treated incorrectly as outside the scope of VAT in VAT accounting periods that ended within the last 4 years.  


This is only disapplied for taxpayers who have had a specific ruling from HMRC stating that such fees are outside the scope of VAT, in which case, such taxpayers would be required to account for VAT on such fees received on or after 2 September 2020.