On 2 September 2020, HMRC made an announcement in the form of the Revenue & Customs Brief 12/2020 stating that as a result of European Union case law, it was changing its published guidance on the VAT treatment of both early termination payments and other compensation payments relating to commercial contracts. In that document, HMRC set out a new general rule that most such payments would now be subject to VAT instead of outside the scope of VAT as the guidance previously stated.

Following representations from industry, the Revenue & Customs Brief 12/2020 issued in September 2020, was subsequently suspended in January 2021 with HMRC reviewing the policy in the light of those representations and are seen to be adopting a revised policy which will take effect from 1 April 2022.

Historically, HMRC took the view that payments described as “compensation” were typically outside the scope of VAT. Similarly, damages calculated according to provisions in a contract, such as liquidated damages were taken to be compensation for loss of earnings which was not subject to VAT. However, if a termination payment was not made pursuant to the terms of the original contract, however, then the separate termination agreement concluded at the time of termination indicated that the payment was in exchange for a ‘right to terminate’ which was subject to VAT. 

This guidance was highly criticised for its backwards approach and heralded the withdrawal of the 2020 Brief.

Revenue and Customs Brief 2 (2022)  

HMRC’s policy is now that most early termination fees and some cancellation fees are therefore liable for VAT if the goods or services for which the fees have been paid are liable for VAT even if they are described as compensation or damages.

This means that fees charged when customers terminate a contract early will be regarded as further consideration for the contracted supply. For example, where a customer is charged a fee for exiting a mobile phone contract early, or if they terminate a car hire contract early, the fee will be liable for VAT, according to HMRC.

Where a party agrees to do something in return for a fee, how that fee is described does not affect whether there is a supply for VAT. What matters is whether something is done and if there is a direct link between what is done and the payment received, and reciprocity between the supplier and the customer, HMRC’s guidance states.

It must therefore be considered that the guidance to HMRC officers will recognise that there will be cases that are not ‘clear cut’ and advises HMRC officers to ‘make a judgement as to whether the charge is sufficiently linked to the supply or not, weighing the factors and the economic reality’. In many cases, there will likely be a fine dividing line between a charge being outside the scope of VAT and falling to be taxed at the standard rate, with potentially significant financial consequences. As such, clear representations will need to be made to HMRC on those border-line cases, carefully considering all of the relevant factors.

All businesses must adopt the revised treatment no later than 1 April 2022. This includes any business that has had a specific ruling from HMRC saying that such fees are outside the scope of VAT.

Any business that adopted the treatment outlined in the September 2020 guidance and accounted for VAT on transactions which under the revised guidance are outside the scope of VAT may correct this on their next VAT return.