15 February 2022 
Andrea Marshall, Tax Specialist
This News Article is relevant to BUFDG and HEPA members.
A European Court of Justice case, Vodafone Portugal, considered whether termination fees that were charged by Vodafone if a customer exited a mobile phone contract early, were subject to VAT. The Court ruled that there was a sufficient link between the exit charge and the main supply in the contract. So, as the mobile phone contracts were VATable, the early exit fee was also VATable.
This case has led HMRC to review its treatment of termination and compensation payments. Historically, such payments have usually been treated as outside the scope of VAT. The final version of HMRC’s guidance has been issued in Revenue and Customs Brief 2 (2022): VAT early termination fees and compensation payments and announces changes that will come into effect from 1 April 2022. (It replaces RCB 12(2020) which was challenged by businesses and has now been withdrawn.)
RCB 2(2022) should be read in conjunction with this HMRC internal guidance:
Universities will now have to consider the type of termination/exit/compensation payment being made (which are set out below), whether it will from 1 April 2022 be subject to VAT, and potentially budget for VAT on additional payments.
This is now likely to follow the VAT liability of the main contract; if the contract is subject to VAT, then any termination/exit charge is also likely to be subject to VAT. So, when triggering early termination of a contract, it would be prudent to budget for VAT. Examples of early termination payments that are subject to VAT are:
HMRC say in their guidance:
… payments that arise from a contract which is broken due to a cause attributable to the customer, being charged to cover the costs to the supplier of making the supply available, or equivalent to what would have been charged for the supply had it gone ahead as intended, will be further consideration for that supply.
However, if the payment is punitive, then it can still be treated as outside the scope of VAT. An example of this would be a £60 parking fine when you have exceeded the parking time paid for in advance by pay and display or similar.
HMRC say in their guidance:
If …[the]… fee is at a level such that it is clearly punitive and is designed to prevent breach rather than to compensate for lost income, then the link between that payment and the supply is not sufficient to regard it as additional consideration, and it will be outside the scope of VAT.
HMRC accept that there are still instances where there is not a sufficient link between the additional payment made and the original supply. The examples given include:
This is referred to as “reduced consideration” in HMRC’s guidance. An example would be reductions in the payments due under property development contracts because there are faults or glitches.
The current VAT treatment will not change, so where there is a reduction in the price payable under a contract, then any VAT due should be calculated on the amount actually paid (not the amount due under the contract). If an amount has already been invoiced, then a credit note plus VAT should be issued by the supplier.
HMRC say in their guidance:
Where a supplier breaches the terms of a contract, rather than the customer doing so, then they may reduce the price they charge for the supply, as what is being supplied has been altered. This will result in less VAT being charged if the supply is taxable. If the adjustment is made retrospectively the supplier must adjust the VAT …. Price adjustment in these circumstances are common practice and if the customer is asked to pay less it is likely that in economic reality the price has been reduced to reflect the lower value of what was actually provided
In a small number of instances, a penalty or compensation might be payable by the supplier. For example, compensation may be payable by a developer because student accommodation is not ready on time, so the university is short of rooms and has to make alternative arrangements, incurring additional costs. Such a payment will continue to be regarded as compensation and outside the scope of VAT.
HMRC say in their guidance:
If the price is not adjusted, but the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered as a result of the breach the payment will be outside the scope of VAT. This might happen where the knock-on effect of the supplier not fulfilling the supply as originally agreed result in substantive costs to the customer for which they seek recompense. The payment may bear little relation to what was provided and if this is the case the payment will not be sufficiently linked to the supply to be treated as reduced consideration.
It is recommended that the university check to see if it makes any termination or compensation type additional charges to customers.
The good news is that some charges, even if they now follow the liability of the original supply, will still not be subject to VAT, because the underlying supply is exempt. For example, a charge made to a student if they decide to leave a course or vacate student accommodation early, will not give rise to an additional VAT charge as the main supply of education or student accommodation is exempt from VAT.
The areas that where there may be VAT issues include:
If you have any further questions or comments, please contact Andrea.
