New VAT Rules on Termination and Compensation Payments

Readers may recall HMRC’s sudden change of policy a few months ago indicating that, in their view, most termination and compensation payments, including dilapidations were now subject to VAT. Following widespread resistance from the property industry, HMRC retracted the new policy for the consultation they should have carried out in the first place and have now published updated guidance.

The new treatments take effect from 1 April 2022 and are likely to affect all forms of early termination of contracts and compensation arrangements.

The overall impact is that apart from a few specific circumstances, HMRC have maintained their view that most such payments are subject to VAT.

Early terminations

For early termination of a contract, HMRC now regard all such payments as subject to VAT irrespective of whether the original contract envisages such a termination or not. HMRC’s analysis on this, driven by several recent VAT cases, is dubious to say the least, particularly given their view that any liquidated damages required by or envisaged in a contract will also, in most cases, now be subject to VAT. Following pressure from the industry and professional bodies though, HMRC have retreated from their previous unsustainable position and now accept that the new policy only applies if the goods or services supplied under the contract were themselves subject to VAT. This will not therefore apply to residential leases or commercial leases without an Option to Tax in place which are exempt from VAT.

Where contracts allow for early termination in a specific circumstance on payment of a fee, we now have a new concept – that the payment is likely to be subject to VAT as further consideration for the supply under the lease if the payment is commensurate with either the costs of making the supply, or to what would have been charged under the contract had it run its course.

Importantly though, the revised guidance does now accept that not all termination payments provided for under a contract will necessarily be considered for VAT purposes or subject to VAT and stresses the requirement for a clear link between the payment and the supplies of goods or services under the relevant contract.
It remains to be seen whether HMRC will treat payments made by a landlord or to a landlord in the same way or analyse the supplies differently as they do now with possibly different VAT treatments.

Dilapidations

HMRC have conceded that, in most cases, dilapidation payments to compensate a landlord for a breach of contract in failing to return the property in the agreed state, will remain outside the scope of VAT. HMRC’s guidance has been carefully drafted to leave such matters open to scrutiny and we can expect HMRC to question such payments closely for any evidence of the necessary link to either the supplies under the lease or to some other agreement from the landlord.

Liquidated damages continued uncertainty

Finally, HMRC have left the matter of liquidated damages for breach of contract in a somewhat uncertain position, where the VAT treatment will depend on detailed analysis of the contracts to determine what the payment was actually for. Again, we can expect that any assertions that a payment is no more than compensation for economic loss will be challenged vigorously, particularly if the person making the payment will be unable to reclaim any VAT charged.

Would you like to know more?

If you would like to discuss the above or how it may affect you, please get in touch with your usual Blick Rothenberg contact or Simon Newark using the details on this page.