HMRC publishes updated guidance on termination fees and compensation payments and confirms the VAT treatment of dilapidations.

On 7 February 2022, HMRC published Revenue & Customs Brief 2 (2022) (the 2022 Brief), its long-awaited updated guidance on early termination fees and compensation payments.

The Brief itself does not contain much detail, instead referencing the updated guidance contained in  paragraphs VATSC05910, VATSC05920 and VATSC05930 of HMRC’s VAT Supply and Consideration Manual. This guidance provides welcome clarification on issues such as VAT on dilapidation payments payable by tenants and liquidated damages payable to customers by suppliers, areas of considerable uncertainty in the last couple of years.

How did we get here?

Prior to 2020, HMRC guidance stated that when customers were charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply (being compensatory in nature) and therefore were outside the scope of VAT.

In September 2020, and following the European cases of Meo and Vodafone Portugal, HMRC published Revenue & Customs Brief 12 (2020) (the 2020 Brief) stating that its updated policy would now be that these charges would normally be considered to be for the supply of goods or services which were the subject matter of the customer’s contract. The view was therefore that most early termination and cancellation fees would be subject to VAT, even if they were described as compensation or damages.

This reflected an apparent more general trend in case law and HMRC practice whereby the instances that payments that might previously have been treated as compensation and outside the scope of VAT were being narrowed, with this new approach having already been adopted earlier in relation to the forfeiture of deposits and payments for “unfulfilled supplies” as set out in Revenue & Customs Brief 13 of 2018.

The 2020 Brief caused particular consternation in that, as a consequence of this updated policy, HMRC was of the view that taxpayers had been making ‘errors’ in their VAT treatment of such payments and that taxpayers were obliged to revisit all such transactions in the last four years to rectify such errors.

Furthermore, it also subsequently became apparent that whilst the 2020 Brief reflected HMRC’s general view of termination payments, their guidance was very ‘broad brush’ and it was perhaps the case that they had not given sufficient consideration to particular transactions which could be distinguished from this general approach. In particular, concerns were raised with HMRC by the real estate sector as to whether their updated analysis was correctly applicable to certain scenarios such as the payment of dilapidations or the payment of liquidated damages under construction contracts.

Following representations made by industry, HMRC announced in January 2021 that it was suspending the guidance contained in the 2020 Brief and furthermore clarified that it would not require taxpayers to revisit the last four years of transactions. Whilst this latter development was very welcome, this still left taxpayers in limbo whilst they awaited further promised guidance.

Where are we now?

Notwithstanding the comments below on certain specific circumstances, the 2022 Brief re-confirms the general position that early termination fees payable in respect of a contract will usually be treated as further consideration for the underlying supply as provided for in that contract (so subject to VAT if there would have been VAT on payments under the contract had the contract not been terminated). This is the case both when the original contract allows for such a termination or when a separate agreement is reached, and even if the payment is described as damages.

In a real estate context, a good example of this would be a fee payable by a tenant to exercise an option to break its lease as provided for in the terms of the lease. Whereas it was previously the case that such a payment was viewed as outside the scope of VAT, it is likely now that the VAT treatment of the break fee follows the general VAT treatment of supplies under the lease in question (so, if the landlord has opted to tax, the tenant will be required to pay VAT in addition to the break fee).

However, HMRC now accept that there remain instances where termination payments could fall outside the scope of VAT. The 2022 Brief confirms that genuine dilapidations payments (i.e. payments made by the tenant on the termination of a lease for breaches of the repair covenant contained in the lease) are outside the scope of VAT. However, HMRC may depart from this view if in individual cases they find evidence of value shifting from rent to dilapidation payments to avoid accounting for VAT. As before the landlord should ensure it holds adequate documentary support for the cost of repairing its property when adopting the position that a dilapidations payment is outside the scope of VAT.

Payments of liquidated damages by suppliers to customers (e.g. where a supplier breaches the terms of a contract and makes a payment to the customer) will generally be outside the scope of VAT as compensation, although care needs to be taken to distinguish the payment of liquidated damages with the situation where it is simply the case that the price payable under the contract by the customer is being reduced. In the latter scenario, the supplier will need to instead retrospectively adjust the VAT liability of the price payable under the contract.

Clarity has also been provided in respect of situations where a customer uses less of a supply that they contracted for and, rather than paying the amount charged in the contract, is charged another fee to compensate the supplier for loss of earnings. Where that fee is set at such a level that it is clearly punitive and is designed to prevent breach rather than to compensate for loss of income, the payment should be outside the scope of VAT. However, there is a fine line here and we would recommend advice is sought in relation to such payments.

All businesses must adopt this revised treatment no later than 1 April 2022, even if they had previously received a specific ruling from HMRC suggesting a contrary view. The Brief goes on to state that any business which adopted the treatment suggested in the earlier guidance (e.g. where VAT was charged on the payment of dilapidations) may correct this in the normal way. We take from this that HMRC do not require taxpayers to revisit past transactions, but they may do so if it is of benefit to the taxpayer.

Deposits

HMRC make clear in Business Brief 2 (2022) that their updated guidance does not impact the VAT treatment of retained payments and deposits as previously detailed in Revenue & Customs Brief 13 (2018). That earlier guidance confirmed that where a supplier retains a deposit or pre-payment made by a customer in circumstances where the supplier does not actually proceed to supply any goods or services to the customer, then generally the payment of the deposit will follow the VAT treatment of the payments that would be made under that contract had it proceeded to completion (and not viewed as compensation and outside of the scope of VAT as had generally been the case prior to 2018). 

Conclusion

In summary, whilst a significant trend can be seen of the Courts and HMRC narrowing the situations in which payments can be considered as “compensation” and outside the scope of VAT, 2022 Brief is an acknowledgment that there are limits to this approach and that there remain situations in a business context where payments are correctly viewed as compensation and not within the scope of VAT. Going forward, careful consideration should be given to payments which are described as compensation or damages to ensure the underlying reason for the payments is understood and therefore the correct VAT treatment is adopted.