Modifications to VAT and Early Termination Funds

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Changes to VAT and Early Termination Payments

Following the recent decision of the Court of Justice of the European Union in Meo (C-295/17) and a related case, HM Revenue & Customs (“HMRC”) has updated its guidance on the VAT treatment of contractual compensation payments for early termination of commercial contracts. Such payments, irrespective of whether described as compensation or liquidated damages, will now be subject to VAT.

Background

Prior to this update HMRC guidance suggested that contractual compensation payments designed to compensate a party in the event of early termination of a contract fell outside the scope of VAT.

Examples of such payments cited by HMRC in its guidance include obligations to make a payment in the event of early termination due to breach or a payment to cover loss of future rental payments in the case of the exercise of a right to terminate a vehicle lease agreement early.

However, the updated HMRC now provides that such payments are no longer VAT exempt and will be treated as consideration for taxable supply.

Although the updated guidance acknowledges that these payments are often compensatory in nature, HMRC identified that they are created as a result of events envisaged under a supply of goods or services agreement. Therefore, they form part of the agreement and consideration for what is provided under it. It is this direct link between the payment and the supply of goods or services agreement that triggers the application of VAT.

Comment

In light of this updated guidance it is recommended that any such early termination payments are clearly stated in the relevant contract to be exclusive of VAT with the obligation to make payment of VAT being conditional upon receipt of a valid VAT invoice. This could be achieved by way of a general statement to that effect covering any and all payments which may fall due under the contract in question.