These payments have normally been treated as outside the scope of VAT. However, consideration of these types of payments by the European Court of Justice and UK courts has resulted in a revision to the VAT treatment in certain circumstances.
When a customer wishes to end a contract early, the supplier of the goods or services will often be entitled to an ‘early termination payment’. In common parlance, these are described as compensation and have generally been considered outside the scope of VAT, not being seen as consideration for a supply of services.
For example, in the telecommunications industry where a payment was due to the telecoms provider for early termination of a minimum term contract (e.g. 12 month phone contract) this was not considered a taxable supply for VAT purposes and so no VAT was due.
Change in approach
Recent cases from the European Courts have indicated that this is incorrect and we now have updated guidance from HMRC confirming that the UK tax authority will treat payments in respect of early contract termination as within the scope of VAT. In certain circumstances, these payments will now be subject to UK VAT.
The recent changes to HMRC policy has also confirmed that liquidated damages, defined as compensation for loss of earnings, and payments for breach of contract are also to be treated within the scope of VAT. HMRC guidance had previously stated that such payments were outside the scope of VAT.
What does this mean?
This change in policy is likely to have far reaching consequences and requires a sea change in perception regarding compensatory payments. For example, deposits paid on property acquisitions were historically often treated as outside the scope of VAT. Given the new guidance, a VAT conscious vendor may insist that a deposit + VAT is paid to protect against an eventuality where VAT becomes due on the deposit received.
Do I need to do anything?
While it is important that taxpayers apply the correct treatment where they are recipients of such payments, HMRC appear to be taking the position that this treatment applies retrospectively.
The only exception is when a specific transaction had a ruling issued by HMRC. It is therefore important that businesses with income relating to early contract termination, liquidated damages or in respect of breach of contract review historic instances where these were treated as outside the scope of VAT and take a view as to whether or not VAT is now due in line with HMRC’s new interpretation.
There is a very wide range of sectors at risk of these changes, from telecommunications to landlords to lessors of automobiles to property developers – anybody receiving compensation – including potentially the retention of a deposit.
In simple terms, if you receive money from a customer you need to consider the VAT treatment. HMRC are likely to presume VAT is due and the courts are taking the same view in many instances.
The scope of VAT is generally increasing – the courts are ruling most payments are made in return for something – and if so then that is within the scope of VAT.
We therefore recommend that any business that receives these types of payment contact their usual UHY adviser or David Rawcliffe (UHY VAT Manager) on 0207 216 4873.