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How VAT is geared for car lease cancellation

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HMRC recently clarified its thinking on early termination of contracts. But the guidance doesn’t only affect mobile phone contracts – there are VAT implications for leased cars too.

17th Jun 2022
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The VAT treatment of cancelled contracts has had an interesting journey. Historically, the view was that cancelling a contract (such as a mobile phone contract while it still has several months of contract remaining) was seen as compensation and therefore outside the scope of VAT.

But then, following a variety of EU cases, the interpretation changed. HMRC issued a muddled and ambiguous brief, originally in September 2020, but suspended that in January 2021 (that is, reverted back to old rules) and then issued revised guidance in brief 02/2022 (February 2022). Nothing like certainty in the world of tax.

Early termination fees 

On 1 April 2022, HMRC published “new” revised guidance and clarified that when a contract is cancelled early (also known as early termination clauses), then VAT is usually applicable to the payment.

This was on the back of various Court of Justice of the European Union (CJEU) decisions in the cases of Meo and Vodafone Portugal, where the court concluded that termination fees are additional consideration for the original supply and therefore liable to the same rate of VAT as the original supply.

For example, a mobile phone contract might be taken out on 1 January 2022 and be set to run for 24 months at £20 per month. If the contract is then cancelled in April 2022, four months in, the remaining 20 months are still payable by the customer (£20 x 20 months = £400).

Previously the £400 was outside the scope of VAT and as the £20 per month was inclusive of VAT, it meant the actual settlement would be £20 minus £3.33 VAT. So the settlement would be £16.67 x 20 = £333.40, whereas under the new guidance, the customer pays the full £400.

HMRC has revised their internal manual at VATSC05910.

Leased cars

Like mobile phone contracts, leased cars can be terminated early with the customer paying the remaining contract terms. The added complication for lease cars is that most businesses will reclaim 50% input tax relating to the lease cost. Under the old rules, the termination payment would have been outside the scope of VAT in most cases.

HMRC recently updated their Notice 700/64 (motoring expenses, 21 April 2022 update) and confirms in paragraphs 4.4 through to 4.8 that it considers termination payments to be further consideration for the supply – which is consistent with the new guidance. However, this means that a company terminating a lease early will be charged VAT (as per the new guidance) but will only be able to reclaim 50% of the VAT charged within the early termination payment.

Businesses that provide leased cars to employees should take note: should an employee leave then either the company can only reclaim half the VAT. The remainder is an expense to the business, or if the policy is to recharge early termination fees onto the employee, the business can reclaim the VAT in full on the basis it makes an onward supply/recharge to the employee and the employee then ends up with a VAT charge they cannot reclaim.

HMRC’s revised guidance on early lease termination notes that dilapidation payments, which are due when a tenancy ends, continue to be treated as compensation and outside the scope of VAT.

Summary

It is good that HMRC has finally explained its thinking in terms of the new approach to early termination contracts. It is perhaps a little unhelpful that the brief does not explain the various ways in which the new rules apply. Only by reading the separate Motoring Expenses Notice can one see how the new guidance doesn’t just affect mobile phone or Sky TV contracts, but also leased cars.

For a consumer, the “discount” previously enjoyed when terminating a contract for TV or mobile is no longer in play, as many consumer contracts can be for a minimum of 24 months. The addition of VAT on terminating a contract should be factored into the overall decision to contract with the supplier and businesses need to be mindful of the VAT position too, especially with regard to lease cars.

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