Early termination charges and compensation payments – the VAT treatment

Jennifer Lockhart | 13 May 2022

Early termination charges and compensation payments – the VAT treatment

Following two European court judgements, and an internal review, HMRC has now confirmed its view of the VAT liability of charges made for the early termination of a contract.

Historically, HMRC had viewed early termination charges and compensation payments as being outside the scope of VAT. Following the Meo and Vodafone Portugal cases, heard in the CJEU, it was determined that some such charges were in fact additional consideration for a supply of goods or services. As such, they could not be viewed as outside the scope, and would be liable to VAT at the same rate as the main supply.

HMRC’s new policy was detailed in Revenue and Customs Brief 12 (2020), however this was later suspended, following representations from industry. HMRC then further revised its policy, which has now been published in Revenue & Customs Brief 2 (2022) and took effect from 1st April 2022.

Current policy
Where payments arise out of early contract termination, the payment is now seen as further consideration for that contract, and not compensation. The payment will therefore follow the same VAT liability as the main supply and will be taxable where applicable.

Whilst this policy change may have a limited effect on businesses which are VAT registered and able to recover their input VAT in full, there may be unexpected consequences where the VAT charged is not recoverable. This could include, for example, where the cost is incurred by a partially exempt business, a private individual, or an entity that receives non-business income and must restrict its VAT recovery. Additionally, the input VAT recovery may simply be blocked by VAT law. This could include where it relates to business entertaining or certain motoring expenses, such as leased company cars.

If you are concerned that your business may be impacted by this policy change and would like to discuss, please get in touch with our VAT specialists, who will be happy to assist.

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