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Changes to VAT liability of compensation payments

/ 25 September 2020

Malcolm Winter

HMRC has updated its guidance on the VAT treatment of compensation and early termination payments. Following Revenue & Customs Brief 12/2020 issued this month, most payments described as compensation or early termination charges will generally be subject to VAT.

Previously, HMRC’s policy suggested that where an agreement contained a clause allowing the parties to terminate early in return for compensation of perceived losses arising from the termination, such a payment was considered outside the scope of VAT.

HMRC makes the point that compensation payments do not generally arise “in a vacuum” and the test from a VAT perspective is whether there is a link between the supply and any consideration received.  In HMRC’s view, many payments categorised as compensation or penalty payments are simply further consideration for the original supply – so on the basis that there is a connection between the supply and the consideration, VAT is due.

As a result, early contract termination payments are now seen as being subject to VAT.  This includes:

  • cases where the original agreement contained specific clauses to allow for such termination
  • cases where a separate termination agreement is entered into by the parties

These changes widen HMRC’s longstanding policy that VAT applies where no right exists to terminate an agreement. HMRC’s revised policy now suggests that most compensation payments will be subject to VAT.

In addition, liquidated damages and payments for breach of contract are now subject to VAT.  Although the payments under such agreements are designed to compensate one of the parties, in HMRC’s view these payments are part of the original supply under the agreement and are therefore regarded as consideration provided under that agreement.

It is still possible for a compensation payment to be outside the scope of VAT, where there is no clear and direct link between payment and the supply.  HMRC gives an example which involved payments made by governments to farmers for agreeing to cease milk production.  Since the payments were made for the ‘wider good’ there was no direct benefit received by the government as a result of making payments and therefore the payment was outside the scope of VAT.

This change in policy appears to follow HMRC’s policy change in 2019 for retained deposits where a customer has decided not to take up goods or services – for example where a customer pays a deposit to a hotel and does not take up the room.  If the hotel retains the deposit, it needs to account for output VAT even though it has not supplied any service.

One concerning point is that the Revenue & Customs Brief seems to suggest this was always HMRC’s position and therefore businesses that do not have specific rulings should correct any historical errors.  This seems unfair, given the fact that businesses may be expected to go back a period of up to four years. It seems particularly unfair since the original VAT treatment was published in HMRC’s internal manuals.  Businesses which have received rulings stating that compensation type payments are outside the scope of VAT are no longer entitled to rely on such rulings with effect from 2 September 2020.

Our VAT specialists are happy to discuss these changes and how your business should respond to them. Please get in touch via your usual BKL contact or use our enquiry form.

Malcolm Winter

Adviser, VAT

T +44 (0)20 8922 9273
E malcolm.winter@bkl.co.uk

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