HMRC has issued draft guidance on its revised view of compensation, liquidated damages and early termination payments. HMRC now consider that most of these payments should be treated as further consideration for VAT purposes. In particular, dilapidation payments, which are common at the end of commercial property leases, will now mostly be treated as additional rent.
In September, HMRC announced a change in its views of the VAT treatment of many compensation and early termination payments. This caused widespread concern, particularly as some of these policy changes had retrospective effect. Before Christmas, this was withdrawn. HMRC has now published draft changes to its internal manuals for comment. These drafts still contain substantial changes to some long-established VAT treatments, but HMRC now propose that these will be prospective only with effect from 1 February 2021.
The changes follow a number of cases where amounts described as ‘compensation’, contractual penalties or ‘early termination payments’ have been held to be further consideration for supplies of services. Examples include charges for terminating a mobile phone contract or a gym membership before the minimum period, a penalty for returning hired goods late or an excess fee for overstaying in a parking space.
HMRC had previously treated most such payments as outside the scope of VAT. However, going forward, it is clear that HMRC’s default position is that a payment from the customer to the supplier is simply further consideration for a supply. Only where no direct link exists between the supply and the payment will the treatment be different.
HMRC give an example of a charge made by a car hire company for wear and tear. If this is for normal wear and tear, this would be additional charges for hire, so subject to VAT. However, if this is for excess wear and tear, these are damages for not returning the car in the expected conditions, and outside the scope of VAT.
Leasing agreements frequently have provisions allowing the hirer to hand back the goods early, but subject to a penalty charge. These liquidated damages have previously been treated as outside the scope of VAT, although under an industry agreements lessors were allowed to treat them as taxable. Going forward this will no longer be optional and all such charges will be treated as taxable.
One of the most significant changes is to the treatment of dilapidations. Typically, a lease of commercial property will require the tenant to return the property in the same state as at the beginning of the lease. In practice, it is rarely practicable for the tenant to do this, and the parties agree an amount as damages. To date, this has been seen as outside the scope.
HMRC now argue that if the lease had provided for reasonable wear and tear, the rent would have been higher to reflect the landlord’s costs of restoring the building to its original state at the end of the lease. Therefore, if a tenant pays dilapidations to meet the same landlord remediation costs, these are really further consideration for leasing the building. Henceforth, therefore, these payments will be exempt or standard-rated, subject to the option to tax.
The starting point for the VAT treatment of anything is usually the legal agreement in place and this has not changed. However, how something may be described in a contract, and how it is treated for other legal purposes, does not determine the VAT treatment. A payment described as a ‘penalty’, ‘damages’ or ‘compensation’ could well have the same treatment as other payments under a contract.
Going forward suppliers need to consider the substance of what these payments are for. If these charges were built into assessments of pricing, are for receiving more services than originally envisaged, or are for terminating a contract early, then HMRC is likely to view these as additional consideration.
With changes in working patterns, many organisations are finding that they have facilities and equipment they no longer need and will be looking to terminate these arrangements early. Any early termination charge is likely to have the same VAT treatment as the charges for the main services under the contract.
If you are negotiating dilapidations, or any other compensation arrangement, you will need to ensure that the contract is now clear whether these payments are inclusive or exclusive of VAT.
Suppliers should check their contract terms carefully to ensure that they are entitled to add VAT to penalty charges if necessary. If a customer is required to pay a percentage of future charges to terminate early, is it clear whether this is plus VAT?
HMRC’s guidance does not address liquidated damages due from a supplier to a customer. A common example would be a construction contract, which may have provisions for payments in the event that the building is not finished on time. In these circumstances, the same test should be applied – is the payment made in return for something? In most cases, the answer is likely to be ‘no’, and these would remain outside the scope of VAT.
HMRC is inviting comments on its draft, but given the proposed effective date of these changes is 1 February 2021 we anticipate that these changes will be implemented as drafted. If you would like a copy of the draft or to discuss this further please contact a member of our VAT team.