New VAT charge on termination of a car leasing contracts

On 1 April 2022, HMRC introduced a new policy that VAT is generally due on charges for early termination of a contract for goods or services. This replaced its previous position that some early termination charges were not subject to VAT because they were a compensation payment made from the customer to the supplier. 

HMRC has now set out its view on the effect of its new policy on charges relating to the termination of vehicle leases, which was hidden away in an update to its guidance on motoring expenses (VAT Notice 700/64). HMRC says that the fees charged for terminating a contract early are now regarded as further consideration for the contracted supply. Therefore, if a vehicle lease is terminated early, the leasing company must treat the termination payment and any associated rebate of rental as taxable for VAT purposes because it is an additional charge for the rental of the car. 

HMRC adds that for ‘non qualifying’ cars on which VAT recovery is limited under the normal rules, lessees may only recover 50 per cent of the VAT charged on them for the early termination of those leases. This means most organisations who operate company car schemes for employees will have to fund half of the VAT that is now applicable to these charges.  

While this is a view HMRC might have been expected to take as an extension of its new policy, this was not previously spelt out in its primary VAT guidance on early termination charges and compensation payments. As a result, it could be easily missed by those who do not have the resources to track every small amendment to HMRC’s public notices.  

This is not just an issue for car leasing companies and their corporate clients, but it could also directly affect the employees who use company cars. Early termination charges are, in practice, often passed on by the employer to the employee who returns the car. Although HMRC’s notice does not specifically address this situation, the employer would presumably recover VAT in full on the termination charge from the car leasing company but would have to add VAT when recharging it to the employee, who as a private individual cannot recover VAT at all. 

This leaves plenty of scope for errors by those who may not have spotted this low-key change to HMRC’s guidance and complaints from those that have. It should also be noted that, at the time of writing, HMRC has yet to make the same update to other areas of its guidance covering this point on the gov.uk website, leaving taxpayers with contradictory statements on HMRC’s position. A change like this which will undoubtedly affect a wide range of businesses should surely merit a higher profile, joined up announcement from HMRC.

Finally, this may not be an issue just for car leasing companies and their corporate clients, but could also directly affect their employees who use the company cars. Early termination charges are, in practice, often passed on by the employer to the employee who returns the car. Although HMRC’s notice does not specifically address this situation, it raises the question of whether the addition of VAT on these charges from the lessor means that the employer must add VAT when recharging them to the employee. HMRC is understood to be separately reviewing the VAT position of employer schemes where a company car is provided in exchange for a salary sacrifice - will they take this opportunity to clarify the employee’s position on car lease termination payments?