Richard Dalton, tax partner, BDO London - Baker Street, looks at the current position of VAT
On 7 February 2022, HMRC published what appears to be a definitive policy position on the VAT treatment of compensation and termination payments that will apply from 1 April 2022. Businesses should make sure that they understand how the new rules affect them and ensure that their systems and contracts are adapted so that they are compliant by 1 April 2022.
HMRC has clearly listened to feedback (including from BDO) in adjusting its views on such payments and its February 2022 policy stance is more nuanced than the broad approach set out in its September 2020 and January 2021 guidance. HMRC has arrived at a position that many payments are, in all economic reality, extra consideration for the contracted supplies (ie taxable, exempt or zero rated depending on the underlying contract).
However, HMRC considers that payments that are ‘punitive’ in size may, in some circumstances, be treated as compensation (i.e. outside the scope of VAT). While this is a fairer approach than HMRC’s September 2020 policy, it means that the complex nature of such payments does need to be considered carefully: it won’t always be simple to decide if VAT will be due on a payment.
As HMRC guidance has changed over time, companies should review how they have approached the VAT treatment of such payments over the past few years and whether corrective action is now appropriate.
How did we get here?
The VAT treatment of compensation and termination payments has always been the subject of some controversy: the basic issue is that VAT is a tax on supplies of goods or services so how is it to be applied when no supply takes place, but money still changes hands between the contracting parties? Often the answer varies according to the precise circumstances of the situation, and this has led to numerous (sometimes conflicting) court decisions on the VAT position.
Naturally, HMRC reviews all such cases and adjusts its policy and guidance accordingly. A summary of the recent changes is provided below.
September 2020 policy change
Historically, it has been HMRC’s convention that when it changes its written guidance/policy, any amended guidance or policy only has prospective effect. However, on 2 September 2020, with no apparent advance notice to stakeholders or affected industry groups, HMRC announced that it was revising the VAT treatment of early termination fees and similar compensation payments (following various recent CJEU judgments) and the change would have retrospective effect. HMRC stated that this would impact anyone who charged their customers to withdraw from agreements to supply goods or services (although our view was that the impact would be more extensive). HMRC’s new approach was set out in Revenue & Customs Brief 12 (2020).
HMRC issued guidance stating that in its view many payments that were previously considered to be outside the scope of VAT were, in fact, subject to VAT. Furthermore, HMRC stated that those taxpayers impacted should declare VAT in accordance with the usual timescales, ie for past four years, unless they are in receipt of a specific ruling from HMRC on the VAT treatment of specific types of payment.
Unsurprisingly, businesses and advisers sought to point out to HMRC the problems that this approach would create and urge them to reconsider the policy. Read more on the September 2020 announcement.
January 2021 policy change
On 25 January 2021, HMRC issued a short update stating that the new policy position set out in Revenue and Customs Brief 12 (2020) would be implemented from “a future date” (yet to be decided at that time).
It said that, in the interim, businesses could either:
Continue to apply the new policy (announced in September 2020), or
Revert to applying the previous treatment of compensation payment if they wish.
Clearly this was far from a satisfactory position and BDO was actively involved in consultations with HMRC on resolving all the issues that its original change of policy triggered.
The new rules
HMRC’s new ‘Revenue and Customs Brief 02 (2022): VAT early termination fees and compensation payments’ makes the general announcement that HMRC considers that fees charged when customers terminate a contract early will be regarded as further consideration for the contracted supply.
It is important to note that the new rules apply from 1 April 2022 onwards and supersede any clearances and written advice previously given by HMRC on a particular taxpayer’s contracts or transactions and therefore we recommend that all impacted businesses review any income of this nature before April.
HMRC have issued revised internal guidance covering these areas.
Termination of contracts
HMRC’s new general policy is to treat payments arising out of contract terminations as further consideration for the contracted supply (taxable or exempt depending on the contracted supply), where the payments are linked to that supply (which they say will normally be the case).
This applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached. This in particular is a departure from their previous approach and reflects a wider view of the courts that the contract and the ‘labels’ attached to income are not determinative of the VAT position.
The basis for HMRC’s approach is that a customer signed up to the terms and conditions on signing a contract and the consideration under the contract relates to those rights, whether they take them up or not.
HMRC says, where the receipt exceeds the cost to the supplier of making the supply but is broadly equivalent to what the customer would have paid had the contract run as envisaged, it is likely to be further consideration for the supply.
However, where charges are made that are punitive and designed to deter non-compliance, HMRC considers the ‘link’ to the original contract is less clear and receipts will usually not be for a supply. This is in line with HMRC’s historic approach, but appears to be at odds with the approach being taken in the European Court of Justice (CJEU), for example the recent CJEU decision in Apcoa ParkingDanmark A/S, related to fines imposed on motorists by parking companies.
The court there considered that the fact fines were punitive or treated as fines under local laws was not relevant and principles of ‘fiscal neutrality’ demanded that VAT apply to the fines as well as the parking, so that ‘good’ parking and ‘bad parking’ are treated similarly. Whilst the UK is not bound directly by decisions reached after Brexit, the UK is still bound under ‘retained EU law’ to uphold the principles of fiscal neutrality, so there may still be arguments related to HMRC’s approach.
HMRC provide examples to demonstrate their thinking.
If a customer pays a fee for exiting a mobile phone contract early, or if they terminate a car hire contract early, HMRC says the extra payment will be further payment for the underlying contract and will usually be subject to VAT.
If a hired car is due to be returned by 9am on a Monday but is not returned until 5pm on the following Tuesday, a charge for late return will normally be made. HMRC says even though the charges are often designed to both deter the person hiring the car from bringing it back late and to compensate the hire company for the additional use, the charge is still subject to VAT as it is for the supply of the car, and the customer is aware that an additional charge will be made and how much that charge will be or how the charge will be calculated.
A termination fee arises where the underlying contract was for an exempt supply. HMRC agrees, as the termination or compensation payment is linked to that contract, the payment would be further payment towards that exempt supply. Note: This differs from HMRC’ policy announced on 2 September 2020 which suggested that all such payments were liable to VAT at 20% regardless of the nature of the underlying supply.
Not additional consideration
HMRC considers a fee charged where the customer writes off a car would not be further consideration for the hire of the car. The supplier has not agreed that the customer can write the car off, and this is not a normal situation like a hire. The fact the contract may envisage the possibility that the car will be written off and provide for a fee to be paid should that eventuality arise changes nothing as there is no direct link to the basic hire service. This approach and differentiation may apply more generally, for example the equipment hire sector.
Dilapidation payments made to landlords
Dilapidation payments arise when tenants exit leases. They vary in the way they are provided in contracts for but broadly they exist to ensure that landlords are not out of pocket if buildings are not returned in the agreed condition at the end of a lease.
HMRC confirms that their policy continues to be that these are normally outside the scope of VAT (this was uncertain in the September 2020 guidance). However, HMRC has made it clear they may depart from that view if in individual cases there is evidence of ‘value shifting’ from rent to dilapidation payments to avoid accounting for VAT.
HMRC’s new guidance effectively says that the VAT treatment of a parking fine or additional fee applied by a car park operator depends on the nature of the charge:
If the charge is effectively an additional charge for occupying a space, then it would be additional consideration for parking, which is normally standard rated.
Where the fine is substantial and ‘punitive’ and is designed to deter a breach of the terms and conditions of parking, it will be outside the scope of VAT (as there is not sufficient linkage to the ‘supply of parking’).
As noted above, this approach differs from the position taken by the is in line with previous decisions of the senior UK courts, for example the Court of Appeal (CoA) judgment in Vehicle Control Services. The CoA considered that parking enforcement ‘fines’ were akin to damages for trespass under land law. Therefore, it does appear that, whilst HMRC has arrived at the same overall finding as the COA, the reasoning is not the same.
Payments for liquidated damages arise from agreements that allow for early termination and will often include clauses that provide a formula for payments in the event of such a termination. The amounts are generally expressed as being ‘compensation for loss of earnings’.
HMRC’s new guidance states that, in the light of the caselaw they rely on, liquidated damages need to be considered carefully to determine whether they are consideration for supplies. HMRC makes the point that, although the payments are partly designed to compensate, they are made as a result of events provided for under the contract for supply. Therefore, as part of the agreement,
if they constitute costs to the supplier of making the supply available or
equate to what would have been charged for the supply had it run as expected, they may be further consideration for the supply.
For example, HMRC says that if a customer uses less of a supply than they contracted for and does not pay the amount agreed for the supply in the contract, but is instead charged another fee to compensate the supplier for loss of earnings, this will normally be consideration for the original supply.
However, it is still the case that if the charge is at a level that is clearly punitive (ie designed to prevent breach rather than to compensate for lost income), then the link between payment and supply is not sufficient, and the charge will be outside the scope of VAT.
What businesses should do now
Businesses should consult their VAT advisers to actively review the guidance set out in Revenue and Customs Brief 2 (2022): VAT early termination fees and compensation payments and seek to establish:
Whether the way they have dealt with compensation payments since September 2020 requires remedial action.
If they need to change their systems and contracts to remain compliant with the new guidance.
Which of their contracts/terms in contracts may result in income not being subject to VAT. There needs to be consideration of the VAT treatment in all cases.
Whether it is now necessary to obtain a new or revised clearance from HMRC to give certainty on HMRC’s agreement on the treatment of your specific income.
It is important to appreciate that this ongoing issue does not involve any new law, which under UK and European retained law does not specifically address what is not subject to tax. It is HMRC’s policy and the nature of business is that there may still be a number of receipts where differing views apply as to the VAT position. The Courts also will take a view when they see disputes and almost always ignore any HMRC policy when deciding matters. Therefore, whilst it is good that we have a clearer understanding of HMRC’s position, this is unlikely to be the end of this matter.