Following the CJEU decisions in Vodafone Portugal (C-43/19) and MEO (C-295/17), HMRC has updated its guidance to make it clear that early termination and compensation payments are in most cases consideration for goods or services and subject to VAT (see Revenue and Customs Brief 12 (2020)).
HMRC’s previous guidance stated that a customer’s payment to withdraw from an agreement to receive supplies of goods or services under a "right to terminate" or as a consequence of the termination of that supply by the supplier could generally be viewed as compensation and outside the scope of VAT. Within the leasing industry, HMRC permitted lessors to treat lease terminations as taxable supplies if so wished.
The revised guidance provides that payments arising out of early contract termination (whether in connection with a pre-existing right or a separately agreed arrangement) will generally be treated as consideration for a taxable supply. This now means that the voluntary regime of VAT application to lease terminations by lessors is overridden by a requirement to apply VAT.
HMRC’s updated guidance states that the following types of payments made by customers, regardless of whether they are made in exercise of a "right to terminate" or are described as "compensation" or "damages" are generally to be treated as consideration and subject to VAT:
- early termination payments to accelerate or end a lease (e.g. voluntary prepayment or payment on voluntary termination);
- payments for breach of contract (e.g. early termination fee payable upon default);
- liquidated damages (e.g. amounts paid under a contract expressed to be "compensation" or for "loss of earnings"); and
- early upgrade fees.
In MEO, the telecommunication services contract stated that on early termination, the customer was to pay a fixed sum representing the remaining amounts payable for the minimum commitment period. The CJEU held that the termination payment was consideration for the right to receive the services which the customer chose not to use.
In Vodafone Portugal, the method for calculating the termination payment under the telecommunication services contract was restricted under Portuguese law to Vodafone’s cost of providing the service. Vodafone therefore sought to distinguish its case from MEO arguing that the payment was intended as compensation. The CJEU held that the character of the payment did not change to compensation because from an economic perspective, the amount payable on early termination was an integral part of the price the customer agreed to pay under the contract. The payment was therefore consideration and subject to VAT.
As a result of HMRC’s updated guidance, there are likely to be fewer situations where HMRC will accept that early termination and cancellation fees, however expressed, genuinely fall to be treated as compensation and not subject to VAT. However, a customer’s payment may be outside the scope of VAT where it does not have a direct link to a supply of goods or services.
HMRC has also called for businesses to take corrective action for any VAT that has not been properly accounted for past periods. Given HMRC’s earlier contradictory guidance, we think it is likely that suppliers following the earlier guidance may seek to challenge retrospective application.
Next steps
In existing agreements, a general VAT clause permitting the lessor (or supplier) to charge VAT on top of all payments should suffice to permit the charging of VAT on early termination and cancellation payments, however expressed. Where such a payment is agreed outside an existing agreement, care should be taken to ensure that a general VAT clause is included.
To the extent that VAT has not been demanded on such payments in past periods, in the absence of a successful challenge to the retrospective application of the HMRC guidance, action may need to be taken to recover the VAT payment from the customer.
There are significant consequences for all affected businesses and different strategies to deal with the tax situation, depending on the facts. DLA Piper’s Asset Finance and Tax teams are well positioned to assist clients with respect to any VAT exposure the new guidance may generate.
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