Neil Warren, independent VAT consultant, gives practical examples of how a recent change in the interpretation of the law by HMRC will affect clients.
From 1 April 2022, HMRC’s revised guidance on the legislation for termination fees and compensation payments came into effect. This is a specific date, rather than any link to VAT returns submitted by a supplier.
The main outcome of the new policy is that if a business or person pays a supplier a fee to terminate a contract early, the payment will be subject to VAT if the payments made within the contract were also VATable. In other words, the payment relates to a contract for standard-rated services. This is a major change from HMRC’s previous policy that a termination payment was outside the scope of VAT because it did not relate to any specific supply of goods or services. See Revenue and Customs Brief 2 (2022): VAT early termination fees and compensation payments.
The Court of Justice of the European Union
HMRC’s change in policy was prompted by the outcome of two VAT cases heard several years ago in the Court of Justice of the European Union (CJEU). The UK was still a member of the EU at the time and they both related to assessments raised by the Portuguese tax authorities for fees charged by mobile phone suppliers for the early termination of contracts.
The CJEU decided that the payments were directly linked to a supply of services from the mobile phone company to their customers and were therefore subject to VAT. It made no difference whether the termination fee required the full amount outstanding on the contract to be paid or whether it was discounted. In other words, mobile phone customers were receiving a benefit for their payments – namely the right to quit early. See Meo (Case C-295/17), and Vodafone Portugal (Case C-43/19).
What about past supplies?
HMRC originally published Revenue and Customs Brief 12 (2020): VAT early termination fees and compensation payments when the CJEU cases were first decided and intended to apply its new interpretation of the rules on a retrospective basis. That would have created massive complications.
Thankfully, the latest brief gives a clear start date of 1 April 2022 for the new rules. No action is therefore needed to review past returns. However, if any clients have charged VAT on past termination fees up to 31 March 2022 – as a result of the earlier brief – these can be treated as errors and corrected, in accordance with the usual procedures. See How to correct VAT errors and make adjustments or claims (VAT Notice 700/45).
Practical situations
The new procedures will affect both suppliers and customers. Here are two practical scenarios.
Example 1
ABC Cleaning Services has a three-year contract with an insurance business to provide office cleaning services. The insurance company is relocating to a different city, so will pay ABC a termination fee to end the contract early, equal to six months of cleaning charges. ABC must charge VAT on the fee following HMRC’s revised policy. This will be an extra cost to its customer because insurance businesses are partially exempt with an input tax restriction.
Note: it makes no difference whether the termination payment relates to a separate agreement made by the two parties or a specific clause in an existing contract; it is standard rated in both cases.
Example 2
DEF Accountants took out a three-year mobile phone contract in 2021, paying £2,000 per month plus VAT. The partners want to cancel the contract early because they want a more up-to-date phone system from another supplier. The existing supplier has agreed that DEF can pay a one-off fee of £10,000 to cancel the contract early. This fee will be subject to VAT – it is classed as an extra payment for the supply of the standard-rated phones. DEF will pay £12,000 including VAT and claim input tax of £2,000 on its next return.
Note: HMRC has updated its VAT manuals to reflect the new procedures – see HMRC’s VAT Supply and Consideration Manual at VATSC05910, VATSC05920 and VATSC05930.
Non-VATable payments
Many compensation and damage payments will continue to be outside the scope of VAT. The challenge for any supplier is to stand back and ask the question: am I giving any benefits to my customer in return for this payment?
For example, if you hire a car and return it to the hire company with a dent in it, you will be charged a damage fee by the hire company. This is outside the scope of VAT because you are not receiving any benefits from the company; you are compensating them for the damage caused to their vehicle.
In situations such as this, it is important that a customer does not accept an incorrect VAT charge from a supplier, even if it issues a tax invoice showing that VAT has been charged. Don’t forget that input tax can only be claimed if VAT has been correctly charged in the first place.
Example 3
Acorn Guest House makes a charge of £250 to any guests who smoke cigarettes in their room, to cover the cost of potential cleaning expenses. This is a ‘penalty charge’ to the guest and is outside the scope of VAT. The guests are not receiving any benefits, unlike a termination fee for exiting a mobile phone contract early.
Dilapidation payments
A dilapidation payment is paid by a tenant to their landlord at the end of a property lease, to compensate the landlord for any repair work needed. HMRC originally intended to treat dilapidation payments as being subject to VAT following the two CJEU decisions about mobile phone contracts if the landlord had opted to tax the building in question. However, HMRC has now confirmed that any dilapidation payments will continue to be outside the scope of VAT. This is good news for tenants who cannot fully claim input tax. See HMRC’s Land and property (VAT Notice 742), para 10.12.
Car park operators
VAT enthusiasts will be interested in another recent CJEU case about whether parking penalties charged by a car park operator were subject to VAT.
Apcoa Parking Danmark (Case C-90/20) operated car parks on private land under agreements with site owners. Similar arrangements are common in the UK, where supermarkets might engage an operator to oversee and fix rules for parking at their stores.
Apcoa set the conditions for using the car parks, and imposed a €69 ‘control fee’ if drivers did not comply with them (eg, exceeding the permitted parking time or parking across multiple bays).
The CJEU considered the facts of the agreements and concluded that such fees were subject to VAT. There was a requirement to pay the control fees as part of a legal relationship created between the taxpayer and the driver when they decided to park their vehicles on the site. In other words, the driver had to comply with the general terms and conditions for using the car park.
The CJEU decided that the penalties represented additional consideration for the ‘excessive use’ of the car park. There was a link between the control fees and the provision of parking. Apcoa’s VAT rebate claim of €3.37m on the control fees was rejected.
Conclusion
The question ‘Is there a supply for VAT purposes?’ must be considered for every payment to decide if it is standard rated or outside the scope of VAT. The VAT position does not change just by using certain words on a sales invoice such as ‘compensation’ or ‘damage payment’. It is all about what benefits the customer is receiving in return for their payment.
About the author
Neil Warren, CTA (Fellow), ATT, an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997