Updated 21st January 2020
On Friday 18th January, HMRC shared an update on the question of early termination payments. Whilst there is still a way to go, HMRC now accepts that there should be no retrospection. They have given a specific comment on dilapidations payments which they consider are further consideration for the underlying supply where the work is noted in the contract.
The update is as follows;
- HMRC consider that it has an arguable case to not apply this change retrospectively. In light of this, they will not apply the change retrospectively.
- Instead, the change will apply from 1 February 2021.
- Where we are already in litigation, HMRC will consider the facts and whether any alteration to the line taken to date is appropriate and communicate that to the businesses concerned.
- HMRC plan to provide interested parties draft guidance before Christmas for comments, with responses due by 12 January 2021. They will then consider if any changes are needed and update the guidance and issue a Business Brief before the beginning of February. RCB 12 (2020) will be withdrawn.
In broad terms, HMRC deems that early termination and similar payments will be considered for the supply if they form a cost component to the supplier of making the intended supply available or are broadly equivalent to what would have been charged for that supply. This is consistent with the judgements in MEO and Vodafone Portugal. Where a charge is made which is provided for in a contract, but which is not directly linked to the intended supply, it will be outside the scope of VAT.
The following examples help to illustrate this:
- Dilapidation payments – (Where contracts require tenants to return the property at the end of a lease in the same condition as when it was first occupied, and if they do not do so the landlord may charge them for the costs incurred in doing that work). These payments are further consideration for the supply where the work is to make good use permitted under the contract. There is a direct link between the payment and the supply, and there is reciprocity as the tenant has signed up to return the property in the condition they obtained it. If the tenant had gone beyond what was permitted under the contract then the charge to rectify this would be outside the scope. It would not be for the supply as the landlord had not agreed to the usage and so the necessary reciprocity would not exist.
- Car Hire – If a payment is required from the customer when a car is written off in the course of hire, the payment lacks the necessary link to the intended supply of car hire, as the supplier does not agree in the contract that the customer can write the car off (even if the contract makes provision for such an eventuality). The necessary reciprocity is not present in order to link the supply and consideration. The fee for writing off the car is therefore outside the scope of VAT. The same is true of charges for excess wear and tear (that is wear and tear greater than that consistent with normal use of the car in the hire period).
September 2020 update as follows
When HMRC recently issued a Brief setting out changes to the VAT treatment of compensation and early termination payments, the guidance was given in the context of a recent European court ruling relating to cancelling mobile telephone contracts. Closer inspection, however, highlights the danger from any HMRC or Government announcement of a change in approach – the potential for the change to have an unexpected impact or consequences in other sectors.
Hitherto HMRC’s guidance made clear that when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT. Most early termination payments have been treated as compensation for the loss of future profit, and therefore not subject to VAT. However, HMRC has now concluded that these early termination fees should be subject to VAT, because it is considered that the payments represent a charge for the supply of goods or services which a customer contracted for. HMRC say that most early termination and cancellation fees are therefore liable for VAT – even if they are described as compensation or damages.
Consequences for the Real Estate sector
The Real Estate sector is likely to be impacted significantly by the change in approach. The new policy raises a concern that VAT is liable to be charged on lease “break payments” / early termination payments whether specified in the lease or negotiated separately between the landlord and the tenant and where the option to tax has been applied. Other property-related payments made to secure the early termination of long-term contracts including liquidated damages may also fall to be subject to VAT – for example, the payment to a facilities management company to terminate a contract early. The policy sees a supply rather than outside the scope compensation.
It is also possible for leases and other agreements to terminate early if a particular event occurs such as the customer breaching the terms of the lessor or an associate business calling in receivers. Contracts may stipulate that such events cancel their terms or effectively allow the lessor to terminate as though there had been a breach and require a fee to compensate the lessor. As with other payments envisaged under a contract, this is a further consideration for a supply and will be subject to VAT.
Dilapidation payments have long been treated as compensation for tenants’ failure to meet their lease obligations and outside the scope of VAT. The new policy does not affect this position, as true dilapidation payments stem from the tenants’ failure to maintain the building during the lease – but it is important that agreements reflect the position correctly and accurately.
In a further twist, HMRC’s announcement broke with the normal approach of making changes in tax policy applicable prospectively. HMRC have set out that they consider that the policy applies retrospectively and requires taxpayers who may not have accounted for VAT on such fees to correct the errors for supplies in the last 4 years. If taxpayers have had a specific ruling on the point from HMRC (and getting rulings from HMRC is increasing challenging these days), their treatment can change prospectively from the date of the HMRC announcement on 2 September 2020.
We understand that representations have been made to HMRC in relation to this retrospective tax-grab, on the grounds that taxpayers have a legitimate expectation to rely on HMRC published guidance and fiscal certainty but there is no indication that HMRC will alter that approach. It could even be seen an opportunistic tax-gathering measure in the current circumstances.
Given the new guidance, taxpayers who have paid or received compensation, termination payments or similar should review the contractual and VAT treatment and consider an adjustment if appropriate. The VAT team at Henderson Loggie would be happy to provide assistance in that process if required.