HMRC cancellation fees

HMRC’s new policy on cancellation fees and early termination charges threatens a surprising number of businesses with backdated VAT bills, despite historic guidance to the contrary. Has HMRC overreached its authority, and how can businesses protect their position?  

What has changed? 

HMRC has historically accepted that payments described as compensation were typically outside the scope of VAT. This is on the basis that HMRC did not view these costs as consideration for any supply of goods or services.

This view was narrowed last year, when HMRC imposed VAT on retained deposits (eg on cancelled hotel room bookings and leisure activities). HMRC has now gone further by announcing a new policy on the VAT treatment of early termination fees and compensation payments.

HMRC views that recent European court judgments mean charges made to customers who withdraw early from agreements, such as mobile phone contracts, TV and broadband subscriptions or vehicle finance leases, are payment for the supply of services under the terminated contract. This means that most early termination and cancellation fees are therefore subject to VAT, even if they are described as compensation or damages. 

HMRC also extends its new policy to other compensation payments, saying it is only where there is no direct link between a payment and a supply of goods or services that these payments may be VAT free.

What does this mean to businesses?

Somewhat concerningly, HMRC says that its new policy has retrospective effect, and therefore businesses must now account for VAT on payments received within the last 4 years. Not only does this contradict HMRC’s usual practice not to apply European court judgments retrospectively but, until September 2020, HMRC’s own guidance stated these payments were generally outside the scope of VAT.

HMRC says that only businesses that hold an individual written ruling that these payments are not subject to VAT are excused from a retrospective VAT bill. Even then, they have been told that they must apply HMRC’s new interpretation prospectively - with effect from 2 September 2020. 

Businesses therefore need to ensure that not only is the position correct going forwards (specifically that any payments made under contract follow the liability of the remainder of the contract and that VAT is accounted for appropriately), but also that any payments made under contract historically have VAT accounted for correctly. Large businesses will also need to consider the possible consequences of this, should the rules surrounding uncertain tax treatments be enacted into UK law. 

On the other hand businesses which frequently make compensation payments to customers should also consider whether these payments were made under contract and therefore should be VAT adjusting. This could lead to possible reclaims where these payments have historically been treated as outside the scope of VAT. 

How can RSM help? 

There are a number of points that a business can consider to minimise the impact on cash flow and profitability as a result of both the retrospective and prospective changes. 

Where HMRC raise an assessment for underpaid VAT on historic payments of this nature there may still be circumstances in which this can be challenged. We would recommend that the circumstances leading to assessments are reviewed to ensure that all mitigating factors can be considered. 

From a prospective situation, as HMRC now state that the VAT treatment of payments will be driven by the terms and conditions of a contract, it becomes crucial to ensure that the all contracts are drafted to provide a result which both parties intend. We suggest that any clauses in relation to cancellation charges and damages are reviewed by a VAT specialist in light of this guidance and reworded as necessary. 

There is still significant confusion around payments made to customers, which is crucial in the business to consumer environment. We can support businesses in understanding the VAT treatment of payments to customers to protect the cash flow position of a business. 

We can also assist with reviewing the terms and conditions issued to clients and provide guidance as to whether any payments made under that contract will be subject to VAT under HMRC’s new rules, which will provide comfort to a business that it is complying with its VAT accounting obligations. 

Where compensation payments have been made to customers, we can help businesses to understand whether these payments should have been VAT adjusting and therefore whether VAT has been overpaid.


HMRC’s new policy in relation to early termination (and other compensatory) payments is not welcome news and may create additional financial burdens for businesses. It is, however, clear that HMRC expect all businesses to apply the new policy with effect from 2 September 2020 and that most businesses will need to consider the need to make retrospective adjustments.

If you would like to discuss the issues contained above in more detail, please contact Anne Holt.