VAT: Sudden change in supplier termination fee treatment
HMRC has updated the VAT policy on supplier termination charges that must be retrospectively applied, which is just not cricket, says Neil Warren.
Over the years, I have received many queries along the lines of, “Our client is not happy with the service provided by their IT supplier so has cancelled the contract. But to comply with the contact, he must pay the supplier compensation of £20,000. Is this payment subject to VAT?”
This question is important for both parties: if the IT supplier doesn’t charge output tax, HMRC might deem it to be standard-rated and assess the VAT. If the customer pays £4,000 as VAT on the £20,000 fee, HMRC would block input tax if it has been incorrectly charged.
Goalposts have moved
In the past, the usual answer to this query would be that the payment is outside the scope of VAT because it does not relate to any specific goods or services supplied by the IT company. Words such as ‘cancellation fee’ or ‘termination payment’ support this conclusion.
However, the goalposts moved in dramatic fashion on 2 September when HMRC issued Revenue and Customs Brief 12/2020: VAT early termination fees and compensation payments. Both parties to the termination fee must now look at the VAT question differently.
Is there a supply?
Where the word ‘compensation’ is mentioned, this normally indicates a payment outside the scope of VAT. For example, if a hotel guest violates the rule that no smoking is allowed in the room, and the hotel charges him £100, this is a compensation payment to the hotel for the extra cleaning costs caused by the guest’s misdemeanour. There is no supply of goods or services by the hotel in this situation.
Timing of change
I am a bit baffled about the timing of HMRC’s policy announcement. The Brief 12/2020 says the change has been prompted by two “recent” CJEU cases (Court of Justice of European Union) but one of those cases was determined in November 2018. That is hardly recent.
HMRC’s policy team has probably concluded that the CJEU decisions are correct and relate to the mobile phone industry that has a massive VAT yield.
Two cases in European court
The first case, Meo (C-295/17), related to payments made by customers with mobile telephone contracts, who had to make a one-off payment to escape a contract early. The charge was reasonable because the customer had received a discount on the deal because of the extended period of the contract.
The Portuguese tax authorities assessed Meo for output tax on the payments but Meo claimed it did not relate to any actual supply of services and should not be subject to VAT. The CJEU agreed with the tax authority that the payments related to remuneration for a supply of services. The mention of the payment being a ‘penalty’ for early termination was irrelevant.
The other case was Vodafone Portugal C-43/19 with similar principles.
The challenge for tax advisers is to assess each situation and review HMRC’s new guidance in its supply and consideration manual (see VATSC05910 to VATSC05930). The old guidance has been deleted. However, I feel that the key sentence is in the Brief 12/2020 background para:
“Most early termination and cancellation fees are therefore liable for VAT. This is the case even if they are described as compensation or damages.”
Guidance note VATSC05920 confirms that VAT is due even if a separate cancellation agreement is made between the parties, ie outside the terms of the original contract.
The changed way of doing business following Covid-19 makes this very topical. A lot of suppliers are no longer needed in the short term, possibly for longer, and contracts are being cancelled. The contract might include a payment for early termination.
Going back to the opening example of the IT contract, I would have said this payment was previously outside the scope of VAT, but it will now be standard rated under HMRC’s new policy.
Go back four years
The Brief 12/2020 recommends that a business should correct errors for the last four years unless it “had a specific ruling from HMRC saying that such fees are outside the scope of VAT”.
Let’s be honest, this will apply to very few businesses: getting a written ruling from HMRC is as hard as getting a football referee to change his mind once he has awarded a penalty. Those with a ruling must apply the correct treatment from 2 September 2020, when Brief 12/2020 was issued.
The retrospective treatment is harsh for other businesses and questions the whole approach of tax advisers using HMRC’s manuals to help make decisions. HMRC made its manuals available for public viewing so that more questions could be answered without businesses disturbing HMRC’s telephone helpline, a saving of staff resources, and it has worked very well.
HMRC would argue that its job is to apply the law and the manuals are not law. But come on, guys, let’s play the game with a straight bat. I’d have thought this was a classic case of when HMRC should quote those two lovely words that it often uses about past issues: “Light touch.”