In the past, HMRC has accepted that contractually agreed payments due in the event of a breach of contract, and thus amounting to compensation, were typically outside the scope of VAT, because they are not consideration for any supply of goods or services.
Reversal of policy
HMRC's policy was affected, as it should be, by European court decisions on the point. However, a series of more recent European decisions have prompted a reversal of this policy. The latest shift in HMRC policy is perhaps the most worrying, on the grounds that it could affect organisations' historic VAT position.
The first change in this area took place last year, when HMRC imposed VAT on retained deposits (eg on cancelled hotel room bookings and leisure activities). This is on the basis that deposits are consideration for the customer’s right to benefit from their booking, regardless of whether they actually use the service they have paid for.
Extending the principle
HMRC has now gone further by announcing a new policy on the VAT treatment of early termination fees (levied when a customer prematurely cancels a long-term contract) and compensation payments. Revenue and Customs Brief 12 (2020) links to new HMRC guidance setting out its view of recent European court judgements in the cases of MEO (C-295/17) and Vodafone Portugal (C-43/19), concerning fees chargeable to customers who end mobile phone and TV/telecoms and broadband subscriptions before the end of the contractual period.
HMRC says these judgements mean charges made to customers who withdraw from agreements are payment for the supply of goods or services which the customer has been contracted for. Most early termination and cancellation fees are therefore liable for VAT, even if they are described as compensation or damages. HMRC says this applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached.
The new guidance specifically mentions contract termination fees from mobile phone providers, including early upgrade fees, and car leasing vehicle finance leases that customers can cancel after an initial period of hire. HMRC is likely to apply this treatment to providers of TV, broadband and telecom services, which were the subject of the MEO judgement. However, HMRC has also extended 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 it may be outside the scope of VAT. The guidance offers little in the way of helpful examples of when this would be the case.
Adjusting the VAT treatment previously applied
More worryingly, HMRC says that its new policy will have retrospective effect, and that businesses must now account for VAT on such payments made within the last four years. This contradicts HMRC’s usual practice, which is to only apply CJEU judgements prospectively. It is particularly surprising as, until this brief was issued, HMRC’s written guidance clearly stated these payments were generally outside the scope of VAT.
HMRC says that only businesses that hold an individual written ruling that their payments are not subject to VAT are excused from a retrospective VAT bill, and even they have been told that they must apply HMRC’s new interpretation prospectively - with effect from 2 September 2020.
Businesses should review their contracts urgently to see if they might be affected by this change. In the front line are mobile phone companies, providers of telecoms, TV and broadband services and vehicle finance leasing businesses, but HMRC’s new policy is loosely worded and other types of compensation payment could also be dragged into the scope of VAT.
Can HMRC be challenged?
For those affected, there are two possible avenues of challenge:
- Is HMRC’s view of the VAT position correct? The European court judgements in MEO and Vodafone Portugal concern a pricing model that recovers its costs over time (ie the duration of a contractual lock-in period). HMRC’s new policy goes wider– has it gone beyond the authority of those decisions?
- Is HMRC entitled to require businesses to account for VAT on these payments retrospectively? HMRC’s previous guidance may have given businesses a legitimate expectation that any such charges would not be subject to VAT. However, such arguments fall outside the jurisdiction of a VAT tribunal and must be argued through the High Court. The time limits for taxpayers to bring judicial review proceedings are tight and likely to run from the date of HMRC’s brief.
It is therefore important for businesses to consider their position now, and not wait until they have received an assessment from HMRC.