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HMRC updates VAT policy on early termination charges and compensation payments

HMRC has now completed its review of the VAT treatment of early termination charges and compensation payments, and has published long-awaited revised guidance. This is an important release from HMRC given the wide range of businesses that 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.

Background

In September 2020, HMRC issued Revenue and Customs Brief 12 (2020), 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, that charges made to customers that terminate agreements are payment for the supply of goods or services and are generally subject to VAT, 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 had initially proposed.

HMRC has broadly maintained its view that some payments described as compensation or liquidated damages are consideration for supplies (and potentially liable to VAT). It states that compensation payments and liquidated damages will be subject to VAT where there is a direct link between a payment from a 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.

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 types of termination charges and compensation payments that might be affected. This will leave many grey areas that businesses will need to consider in more detail, particularly as 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 these types of charges 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 that 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.