When Should VAT Be Accounted for in Compensation Payments?

07.03.2019

As a rule, VAT is charged only on transactions that involve a supply of goods or services. When paying a compensation fee to another party, it is generally accepted that this does not constitute consideration for a “supply”, which means that VAT will not be due.

However, HM Revenue & Customs recently issued Revenue and Customs Brief 12 (2020), which creates a potential liability to account for VAT on any compensation payments that are envisaged within or can be linked to a contract. This has the potential to create VAT implications that businesses can ill afford to ignore.

What is Revenue and Customs Brief 12 (2020)?

This new ruling represents a complete about-turn in policy by HMRC. Official guidance previously advised that where customers were charged to withdraw from agreements to receive goods or services, these charges were classed as compensation, and therefore outside the scope of VAT.

Following a number of decisions by the EU Court of Justice, HMRC has changed its view. Specifically, rulings on the case of Meo and Vodafone Portugal determined that payments to terminate a contract early were intrinsically linked to the supply made under the terms of the contract, and therefore represented additional VATable consideration for a supply. This applies even if they are described as compensation or damages.

This change of view is of obvious concern, and becomes an even greater issue when reviewing HMRC’s revised internal guidance. As a result, it is now clear that in HMRC’s view, any payment received by a business or organisation that can in some way be linked to a contract for a supply has the potential to be liable for VAT.

The implication for businesses

The new brief sets out HMRC’s view and is stated to not be a change in the law, but a clarification of the correct existing legal position, which has a retrospective impact. This is a real concern for businesses and other organisations such as charities, as it means that any payments to compensate them for early termination of agreements for the last four years may now be subject to VAT, contrary to HMRC’s previous published guidance.

HMRC also states in the brief that it would only consider arguments that no VAT is due on the basis of incorrect advice from HMRC - that is to say, if the business in question has had an explicit ruling on the issue, rather than where it has relied on HMRC’s internal guidance, despite feeling it might be wrong.

This could create problems on a number of fronts, not least of which being that the internal guidance is what VAT inspectors rely on when conducting VAT reviews. As such, a VAT inspector would have been unlikely to issue a specific ruling where a business has not accounted for VAT on such payments in the past, as this would have been considered correct according to the previous guidance.

Examples of areas where this is a risk include:

• Payments from tenants surrendering leases of opted-to-tax properties
• Agents ceasing to act as a matter of principle
• Terminations of franchises

If your business is involved in any compensation agreements, it is therefore advisable to seek expert VAT advice to ensure that you are fully aware of all the potential VAT implications of your future transactions.

For advice on this or any other VAT-related topic, call our free helpline on 0161 477 6600. Our expert advisers will be able to clarify your VAT responsibilities and ensure that you avoid falling foul of a HMRC ruling.