VAT on Settlement of Disputes and Termination of Contracts

As of September 2020 HMRC’s position on early termination or cancellation payments is that they are now subject to VAT, even if the payments are regarded as compensation or damages.  HMRC’s thinking is that the termination fees are to be considered as part of the price that the customer had committed to under the terms of the contract.

Until September 2020 the view was that early termination and cancellation fees were not part of the charges for the supply of goods or services, so would not be subject to VAT – these charges were compensation for losses, rather than consideration for a supply.  The Revenue and Customs Brief 12(2020) announced that HMRC interprets two EU cases that results in extending VAT rules to compensation payments that arise as a result of contract terminations.

This clarification has essentially reversed the previous understanding on such payments, with the presumption now being that VAT will be due unless an applicable exemption can be shown to apply.  According to HMRC’s internal manual, “only where there is no direct link between a payment and a supply of goods or services that [the payment] may be outside the scope of VAT”.

With the now-confirmed VAT status on these payments, customers will now be thinking more carefully about their liabilities when undertaking new contracts.  While this position is less of an issue for VAT-registered customers, whereby the VAT can be reclaimed, those who are not VAT-registered might be less willing to enter contracts that could see them responsible for an additional 20% on top of agreed exit fees.

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