Historically, HMRC has viewed compensation payments as being outside the scope of VAT rather than being consideration for any supply. Following various CJEU and other case decisions finding that similar payments were actually consideration for supplies, HMRC revisited its position on compensation payments. In particular, taking the view that these type of payments will no longer be treated as outside the scope of VAT but will form part of the underlying supply of property rental where they form a cost component to the supplier (i.e. landlord) of making the intended supply available – consequently, either VAT exempt or taxable, depending on the VAT liability of the main property supply. Only where no direct link exists between a payment and a supply will HMRC consider this to be a payment which is outside the scope of VAT [VATSC05910].

Initially, as set out in Revenue & Customs Brief 12/20 dated 2 September 2020, HMRC intended to apply this change in VAT treatment retrospectively, bringing significant uncertainties for affected businesses. However, following representations by a number of public bodies (and the property industry) with concerns regarding these changes, HMRC has confirmed that this will no longer be the case.

This is welcome news, as many businesses have needed to consider whether they would be required to make retrospective adjustments, whether VAT would be collectable from counterparties and whether an extensive review of past transactions would be needed. Given the significant challenges for businesses, taken together with current market conditions and the COVID situation, HMRC has seen sense and therefore taken the right approach in removing retrospective effect of the changes. HMRC initially indicated that any changes would be effective from 1 February 2021, but given it is now already towards the end of January 2021, this may be delayed. Draft HMRC guidance has already been released to stakeholders for comment and the new HMRC guidance is expected to be finalised shortly.  

What type of payments are likely to be covered by HMRC’s changes?

In practice, when considering the VAT treatment of compensation type payments, it needs to be established if the payments being made are sufficiently (directly) linked to a particular supply or not. In some cases, a payment could relate to a combination of items including a supply and other items not considered to be a supply, in which case, an apportionment will be needed.

Although the awaited final guidance from HMRC will include more detail on how this will apply in practice, HMRC’s draft guidance currently gives the following examples of payments that will normally be directly linked to and which will therefore need to be treated as further consideration for a supply. Therefore, if you are planning any compensation transactions, you will need to take this into account so you can consider and plan for any associated VAT arising on these payments.

• Dilapidation payments – historically, such payments were VAT free where provided for within contracts. Going forward, it is likely that dilapidation payments will form part of the underlying supply under the contract itself. For example, HMRC’s draft guidance indicates that if a lease contract did not provide for the tenant to meet these costs, the landlord would instead normally charge a higher rent to allow the building to be restored to its former state at contract end (i.e. HMRC considers dilapidation payments to form part of the underlying supply of property rental).  Therefore, if supplies under the lease are taxable, dilapidation payments will also be subject to VAT.
• Payments arising out of early contract termination – previously, these types of compensatory payments were outside the scope of VAT. These payments are now likely to be normally treated as further consideration for the supply under the original contract where they are linked to that supply. So again, these payments will be subject to VAT where the supply under the original contract was taxable, regardless of whether the termination is provided for under that contract or is agreed for separately (e.g. by way of variation). The same rules apply to early upgrade fees (a type of early termination fee).
• Liquidated damages – the legal position is that these are a fixed or determined sum designed to compensate, as agreed by the parties, usually payable on breach of contract and designed as compensation. HMRC has indicated that although designed to compensate for loss, liquidated damages payments arise as a result of events envisaged under the contract, and so should be treated as consideration for supplies under the agreement. So, if the contract (or lease) is in respect of taxable supplies, any associated liquidated damages would also be subject to VAT. If the contract (or lease) is for exempt supplies, the liquidated damages would be VAT exempt. However, given the scope for interpretation, we do anticipate this is likely to be a topic litigated by traders in the future.
• Breach of contract payments – similar to liquidated damages, where a contract ends due to breach of contract, any associated fee charged by the supplier to cover its costs (or broadly equivalent to what would have been originally charged under the contract) is likely to be further consideration for the supply under that contract, and therefore, subject to VAT if supplies under the contract were taxable.

What payments will remain outside the scope of VAT?

HMRC’s draft guidance gives an example of excess wear and tear fees (i.e. over and above what would normally be expected during a period of hire) continuing to be outside the scope of VAT. Only if part of normal costs of hire have been shifted into an excess fee would all or part of such fees be an additional consideration for the hire.

Unless it can be proven that there is no direct link between a compensation payment and supply under the new rules, other compensation payments are likely to be subject to VAT if the contract is a taxable contract. Payments will not fall outside the scope of VAT going forward unless it can be proved that there is no direct link between those payments and a supply. A number of stakeholders have input to HMRC’s draft guidance commenting that as payments such as dilapidations are not typically recovered by way of lease but under the common law principle of damages, they should remain outside the scope of VAT. Hopefully, HMRC’s final guidance will respond on this and also whether the change in VAT treatment will apply to other situations not yet addressed in the draft guidance. For example, whether payments (such as damages for incomplete works) made by the supplier (say a landlord) to its customer (the tenant) will be caught by the changes or if these will remain outside the scope of VAT as compensation.

What does it mean for me and what do I need to do?

Landlords and tenants will be particularly interested in these developments and will be especially relieved that the retrospective application of HMRC’s change in VAT treatment to compensation payments will no longer be applied.

However, to ensure that the correct VAT treatment can be applied to these type of payments going forward, affected businesses should now review any existing contracts and revisit these where needed, engaging with the relevant counterparty. For example, if existing contracts were drafted on a ‘VAT inclusive’ basis, this could bring particular difficulty if compensation type payments arise in respect of which VAT now becomes chargeable. Similarly, if contracts are silent on VAT, these should at the very least, be urgently amended to contain a general VAT charging clause (to include the wording ‘plus VAT where applicable’) so that landlords can recover any VAT payments from occupiers. 

Where VAT needs to be charged on compensation payments, associated invoices will need to be issued, so there will be an additional administrative/compliance aspect for both parties to address.

In cases where these type of payments are significant, this could also result in cashflow issues where the payments are taxable, as well as possibly some partial exemption considerations where the payments are VAT exempt. Therefore, a commercial discussion will be required on all of this and to agree who will bear the cost of any irrecoverable VAT should it arise.

What should I be doing now?

Affected parties should review existing contracts and make any necessary changes to ensure that VAT can be charged on these payments going forward where required.

If negotiating new contracts, consider the wording of any compensatory type payments to ensure that the correct VAT clauses are included and your position is protected.

We will provide a further update when HMRC’s new guidance has been released. If you would like us to advise you further on the impact of these changes upon your business or if you have any questions on how to be prepared for this change in VAT treatment, please contact us or your usual A&M VAT adviser.