HMRC updates VAT policy on early termination charges and compensation payments

14 February 2022

HMRC has now completed its review of the VAT position of early termination charges and compensation payments, and published revised guidance on the website. This is long awaited guidance and is an important release from HMRC given the wide range of businesses which will be affected.

HMRC’s new policy will come into effect on 1 April 2022, so organisations that pay or receive such sums should review their VAT treatment as soon as possible. 


In September 2020, HMRC issued a brief announcing a controversial new interpretation of the VAT position of early termination fees and compensation payments. Having generally accepted in the past that such amounts were not subject to VAT, HMRC formed the view (based on two European court judgments in C-295/17 MEO and C-43/19 Vodafone Portugal) that charges made to customers who terminate agreements are payment for the supply of goods or services and were subject to VAT. This is the case even if they are described as compensation or damages.

HMRC proposed to apply this interpretation retrospectively, but its guidance gave few firm examples of precisely what would be affected. Faced with strong criticism of its stance from taxpayers, HMRC agreed to suspend the new policy while it discussed its precise scope with stakeholders and promised to issue further guidance once that review was complete.

The new guidance

HMRC has now published Revenue and Customs Brief 2 (2022) linking to its revised guidance on the topic. The new policy will come into force on 1 April 2022 and will not apply retrospectively as HMRC initially proposed.

HMRC has broadly maintained its view (based on MEO and Vodafone) that some payments described as compensation or liquidated damages are consideration for supplies (and potentially liable to VAT). HMRC states that compensation payments and liquidated damages will be subject to VAT where there is a direct link between a payment from the customer and a service provided by the supplier. However, as a result of the review, it has toned down or clarified its position in some important areas.

Key practical points emerging from the new guidance include the following:

  • ‘Dilapidation’ payments due under a property lease (to ensure landlords are compensated when a tenant does not return the property in an agreed condition at the end of the lease) will remain outside the scope of VAT. This is an important confirmation as HMRC had at one point suggested during the review period that it intended to apply VAT to dilapidations on properties that are subject to an option to tax. HMRC does however reserve the right to take action against taxpayers it suspects of avoiding VAT by ‘value-shifting’ property fees from taxable rent to a non VATable dilapidation payment.
  • HMRC explicitly states that fees payable by a customer to a supplier for terminating a contract will usually be consideration for a supply (so VAT will be due if the underlying supply was also subject to VAT). HMRC names mobile phone contracts and vehicle finance leases as examples, but this could potentially apply to any contract where a customer exercises an early termination.  However, despite recent UK case law on the topic, the guidance does not comment directly on how its policy might affect a payment to exercise a break clause in a property lease.
  • HMRC confirms that it will consider VAT to be due on additional payments levied for the late return of hired goods.
  • HMRC says it will generally regard fines (such as parking fines) to be additional payment for the underlying supply, unless the fee is at a level that is ‘clearly punitive and is designed to prevent a breach of contract rather than to compensate for lost income’, in which case it will be outside the scope of VAT. Although understanding the difference will be essential to applying the correct VAT treatment, HMRC seems to be leaving this to the discretion of its officers and provides little guidance on when it might consider a payment to be punitive (outside the scope of VAT) or simply to make up for lost income (potentially subject to VAT).
  • Where it is the supplier rather than the customer that breaches the terms of a contract, and the price of the supply is retrospectively reduced, HMRC says the supplier must adjust the VAT they have accounted for. If the price is not adjusted, but the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered as a result of the breach, that payment will be outside the scope of VAT.

How will HMRC’s policy affect my organisation?

HMRC’s decisions not to apply the changes retrospectively and to continue to treat dilapidation payments as outside the scope of VAT are very welcome. However, given the potentially wide scope of its new policy, the guidance gives surprisingly few firm examples of the termination charges and compensation payments that might be affected. This will leave many grey areas for businesses to consider, for example it can be difficult to determine whether there is a direct link between a compensation payment and a service provided by a supplier.

It will be wise for organisations that make this type of charge to review their terms and conditions before 1 April 2022 to identify any payments that may become subject to VAT as a result of this change. Failure to account for VAT correctly will lead to liabilities, interest and potential penalties.

There is also a potential pitfall for VAT registered businesses who are required to pay early termination or compensation charges to their suppliers. If they are charged VAT incorrectly, this will not be recoverable as input tax by the business making the payment, so it is just as important for the customer to check that its supplier has applied VAT correctly to such payments.  For partly or wholly exempt businesses it is worth noting that payments on terminating a contract or paying compensation may now lead to an additional VAT cost which did not exist under the prior HMRC guidance.

HMRC also states that it will consider claims for VAT overpaid prior to 1 April 2022 in cases where VAT was charged on compensation payments based on the September 2020 guidance, but is not chargeable under the terms of the new guidance.

For more information, please get in touch with Simon Atkins or your usual RSM contact.