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Historically, HMRC has treated many early termination and compensation payments as being outside the scope of VAT because such payments were not considered to be consideration for a supply of goods or services. However, on 2 September 2020, HMRC published revised guidance confirming that it now considers that “only where there is no direct link between a payment and a supply of goods or services” will such payments be considered to be outside the scope of VAT. We look at the implications of this change of approach for clients and the steps they should take now.
HMRC’s change of approach follows two ECJ decisions that contractual payments made by customers on the early termination of their fixed term contracts constituted consideration for the supply of the services for which the customers contracted (telecommunications services), rather than compensation for breach.
HMRC’s revised guidance confirms that, where the contract allows for early termination, early termination fees (including early upgrade fees made when a customer terminates one contract and upgrades to another) are further consideration for the original supply. Further, while liquidated damages payments are designed to compensate, they too will be treated as consideration for supplies because “they result from events envisaged under the contract” and “are consideration for what is provided under it”. Compensation for breach of contract is treated as consideration for a supply for the same reason.
While HMRC’s revised guidance does not expressly confirm the point, it follows that there will be no VAT on early termination and compensation payments where the underlying supply is exempt.
If the contract does not allow for early termination, HMRC’s revised guidance confirms that termination payments are also taxable where they are made in return for a right to terminate early. Here it appears that HMRC considers that the act of granting the right to terminate early is the supply of standard-rated services.
The terms of many leases will provide for a landlord to recover from a tenant a dilapidation payment on or nearing the end of the lease. HMRC’s revised guidance does not expressly deal with dilapidation payments but is so widely drawn that it could be read as covering such payments. Notably, however, HMRC has not changed its guidance on dilapidation payments in VAT Notice 742, paragraph 10.12 of which provides: A dilapidation payment represents a claim for damages by the landlord against the tenant’s ‘want of repair’. The payment involved is not the consideration for a supply for VAT purposes and is outside the scope of VAT. This suggests that it is not HMRC’s intention to change the VAT treatment of dilapidation payments.
HMRC’s clarification of the VAT treatment of dilapidation payments is therefore being sought.
HMRC’s approach on lease break clauses, however, is clear - at least where the lease contains a break clause. If the break clause is exercised to end the lease early and a break fee is paid by the tenant there will be a supply for VAT purposes and the VAT treatment will depend on whether the landlord has opted to tax. It appears that if the lease does not contain a break clause, but the landlord subsequently grants such a right which is exercised, HMRC would treat any compensation paid by the tenant as consideration for a taxable supply.
Generally, a change of HMRC view or practice is prospective only. However, the announcement accompanying HMRC’s revised guidance suggests that HMRC’s change of view is to be applied retrospectively. HMRC states that “Any taxable person that has failed to account for VAT to HMRC on such fees should correct the error”. This means that the recipient of an early termination payment received in a VAT accounting period ending within the last four years must now account for the output tax to HMRC unless the recipient obtained a specific ruling from HMRC that no VAT was due.
Practitioners are, however, querying with HMRC the appropriateness of the retrospective nature of HMRC’s change of approach and it is to be hoped that HMRC will take a different approach. Business should also consider seeking advice on whether they might legitimately rely on HMRC’s previous guidance.
Given the uncertainty surrounding the retrospective nature of HMRC’s change of view, and the unfortunate timing of the announcement, many businesses will want more certainty before expending precious time and resource investigating the historical position. We will keep a close watch on and report developments on this as they occur.
Landlords agreeing dilapidation payments under existing leases will, however, need to consider the VAT position now. Until HMRC clarifies its position on dilapidation payments, approaches will vary depending on the precise circumstances of each case, but could include (assuming the landlord has opted to tax) charging VAT, holding an amount equivalent to VAT in a retention account pending clarification and not charging VAT subject to appropriate contractual protection to enable VAT to be charged if HMRC determines that VAT is due. Additional comfort may be obtained by seeking HMRC clearance.
Going forward, all agreements should be checked to ensure they adequately deal with VAT including the possibility of VAT having to be charged after the agreement has terminated.
20 October 2020