VAT on Compensation Funds in Mental Property Settlements

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VAT on Compensation Payments in Intellectual Property Settlements

This blog is a continuation of our recent blog on HMRC’s surprising changes in VAT and early termination payments. As mentioned earlier, the updated guidelines from the HMRC are proving extremely controversial.

What happened? People are unhappy because the updated guidelines treat termination payments (including for breach or withdrawal or under flat-rate indemnity clauses) as supplies for VAT (i.e. taxable) if they were previously treated as being out of VAT scope.

Retrospective application. Worse still, the VAT changes will be implemented retrospectively. The retrospective nature of the change is at odds with the attitude HMRC normally takes when changing its policy that changes are usually prospective and not retrospective. The HMRC has been the subject of intense lobbying by a number of interested parties, in particular on the grounds that the retrospective nature of the change contradicts the established principles of legitimate expectations. The HMRC is therefore considering its position.

Are all compensation payments now subject to VAT? The change in HMRC’s guidelines does not affect the general principle that pure compensation or payment of damages does not fall within the scope of VAT. The VAT only applies to payments with a contractual term. In determining whether a payment constitutes compensation / damages, it is important to clearly state the exact purpose of the payment. If a payment is purely a compensatory payment or a compensation payment, it does not fall within the scope of VAT. On the other hand, if the recipient of the payment does something for this consideration, a delivery is made for VAT purposes.

Compensation / compensation or consideration? Compensation has been described as making amends or refunding for loss or damage. Only if a payment is not connected with the delivery of goods or services does a compensation or compensation payment fall outside the scope of VAT. While this may sound simple, it is rarely, if ever, clear! The parties should seek specific advice if anything is unclear. A common area of ​​confusion is the distinction between paying for failure to meet the terms of a contract and paying for waiving a right or benefit under a contract. The former is generally not considered to be a consideration and is therefore outside the scope of VAT, and the latter is generally considered to be VAT.

What about IP violations? Subsequently, a payment received by a party for an infringement of intellectual property rights (such as copyright, trademarks, designs, or patents) is not subject to VAT. In this case, the payment will only be regarded as compensation for the violation of a person’s rights and therefore will not be treated as consideration for the delivery. HMRC treats this principle as being for damages awarded by a court in IP infringement proceedings and out-of-court settlements in IP infringement proceedings.

What about contract variants for IP licenses? However, a payment made only to change the terms of an IP license (such as changing the territory or scope) or a payment made to terminate early will have VAT attached. These payment types are treated as consideration for the contractual change. HMRC will only consider these payments to be outside the scope of VAT if the parties can demonstrate that the payment was the result of a due process resulting from a party’s failure to comply with the licensing terms.

Conclusion

A payment does not fall within the scope of VAT if it is not associated with a delivery of goods or services. In order to determine this, the parties must distinguish between a payment of compensation on the one hand and a consideration on the other. Any payment made under an IP infringement regime must be structured as purely compensatory so that VAT is omitted. This must be taken into account when the parties draw up the license conditions.

This blog does not provide legal advice. Contact Carlton Daniel, IP / Commercial Partner, or Tim Jarvis, Tax Partner for assistance with creating IP licenses or assessing whether sales tax may be charged on changes or cancellations or in connection with IP violations.

Written with the help of trainees Moneek Chahal and Franki Scott.