VAT: early termination of a contract

When a customer is charged to withdraw from an agreement to supply goods or services, the situation can be complicated. In VAT terms the tax rules should not be taken lightly, so what is the VAT position and why is it so important now?

In summary

HMRC’s previous interpretation had been that any charges to end a contract early would not apply for VAT purposes, based on the fact that generally the charges were not for supply, so fell outside of the scope of VAT. However, since 1 April 2022 there has been a U turn in the HMRC policy, when key judgments in the Court of Justice of the European Union, resulted in the shift in policy by HMRC.

The new position of HMRC

The new position by HMRC states that if there is an early termination or cancellation fee and the goods and services supplied in the original contract were subject to VAT, then the fee to exit the contract is also subject to VAT. This is substantiated by an example by HMRC guidance where a fee is charged to terminate a car hire or exit a mobile contract agreement early, hence even where payments are deemed as damages or compensation payments, VAT is likely to be applied.

Furthermore, the charges are treated as additional consideration for the supply of goods and services. However, this is on the assumption that there is a direct link between the supply made and the customer’s payment. Where fees are deemed ‘punitive’, such as additional fees where someone overstays at a car park, a clear link with the original supply may be speculative, and in this scenario may result in the fee falling outside of the scope of VAT.

Landlords

The property and land sector is one of the areas that has been particularly impacted by this HMRC clarification. There has been some doubt on what stance HMRC would take on dilapidation payments to landlords – payments at the end of a lease that cover costs incurred failing the property being given back to the landlord in a specified condition. Changes to the status quo had been much anticipated.

However, this latest guidance states that dilapidation payments will in normal cases still fall outside of the scope of VAT: the existing regime continues to apply. It must be noted however that HMRC’s updated VAT manual nevertheless highlights the speculation and potential grey areas that require clarification: ‘We might depart from that view if in individual cases we found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.’

Get in touch

This new guidance means that a large number of payments previously deemed outside of the scope of VAT, may now require different treatment. Our VAT experts will be happy to answer any questions that you may have relating to VAT and early termination of contracts and provide you with further advice and guidance that is applicable to your specific business needs and sector, so please do get in touch.