Compensation Payments Now VATable following EU Rulings

Compensation Payments now VATable Following EU Rulings: Immediate and Retrospective VAT Implications 

HMRC’s recent Revenue & Customs Brief 12/20 sets out a major change in the VAT treatment of payments for the termination of contracts, which had previously been regarded as VAT-free ‘compensation’. Businesses will now be required to treat such payments as subject to VAT, and may also be required to amend historic VAT returns to apply this new treatment

This change follows the CJEU cases of Meo and Vodafone Portugal, which both involved mobile phone/telecoms contracts where the customer was charged a penalty for terminating during the initial minimum period. In both cases it was held that the payment received still formed part of the consideration for the supply under the original contract, and hence was subject to VAT

While both of these cases relate to the telecoms sector, HMRC believe that the principle has much wider application and will apply to all business sectors, and other types of contract in addition to those for ongoing services. They now consider that the following payments would all give rise to an Output VAT liability if the supplies being made under the original contract were standard or reduced rated:

Early termination penalties, whether made under terms included in the original contract or negotiated separately at a later date.

Liquidated damages or payments for loss of earnings arising from termination of a contract.

Other payments arising from breach of contract.

For the avoidance of doubt, if the supply under the original contract was zero-rated or exempt from VAT, the same treatment would apply to any additional payments and no VAT liability would arise.

Amendments to Previous Returns 

HMRC’s Brief states that they expect any businesses who have failed to account for Output VAT on payments such as those set out above to make a voluntary disclosure and correct the position – despite the fact that these would have been treated in line with HMRC’s published guidance at the time!

Where a business considers it Is necessary to make an amendment to its returns as a result of HMRC’s change in position, this would need to cover the standard four-year historic period for error corrections.

One exception to this requirement to amend previous returns is where a business has previously obtained a specific ruling that payments received are outside the scope. In this case, such businesses will only need to account for Output VAT on payments received after 2 September 2020 (i.e. the date HMRC’s Brief was issued).

Other Actions Needed

Businesses will also need to review their contracts going forward, to ensure that termination fees and similar charges included are specifically stated as being subject to VAT. This should ensure that the VAT element can be recovered as an additional amount from the customer, rather than the amount specified in the contract being treated as the gross amount.

Businesses negotiating the termination or amendment of a contract outside of its original terms will also need to ensure that the VAT treatment of all payments to be made is considered.

Leathers would be happy to assist businesses in dealing with this new position, either in terms of reviewing the historic position and making any necessary voluntary disclosure to HMRC, or updating contracts going forward.

Please contact Alex Newsham on 0191 224 6760 or a.newsham@weareleathers.com

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