HMRC to charge VAT on payments for ending contracts early, and possibly on certain lease payments

Businesses whose customers must pay a fee if they end their contracts early, and landlords asking tenants for fees for dilapidations or before they can exercise a break clause, must now consider whether to charge VAT on such payments as a result of HMRC’s new approach, and review their contracts and leases to see if changes need to be made.

In the past HMRC has said that many such payments are not payments (what lawyers call ‘consideration’) for the goods and services supplied under the relevant contract and are not therefore liable to VAT. However, it has now updated its guidance to say that it will consider such payments as not liable to VAT ‘only where there is no direct link between a payment and a supply of goods or services’.

This follows two European rulings that contractual payments made by customers on the early termination of fixed term contracts were payments for supply of (in those cases) the relevant services.

HMRC are therefore now treating payments which customers have to make if they terminate a contract early as if it were a further payment for the goods and/or services being supplied under the contract, so that VAT is payable on them. This includes circumstances where the customer is paying to terminate one contract so that it can upgrade to another contract.

HMRC says it is also applying the same reasoning if a contract requires a fixed sum to be paid automatically by a customer if they breach that contract – sums that lawyers call ‘liquidated damages’. It argues that such payments are liable to VAT because ‘they result from events envisaged under the contract’, which means they ‘are consideration for what is provided under it’.

Businesses whose contracts require a customer to pay a fee if they terminate the contract early and/or which provide for payment of liquidated damages if a customer breaches the contract, should consider whether these payments are now subject to VAT in accordance with HMRC’s new approach.

There are concerns that HMRC’s new approach could also make certain payments under leases liable to VAT – where, for example, the lease says that a tenant must pay a sum for ‘dilapidations’ (ie repairs and maintenance) required at the end of (or shortly before the end of) the lease. This has been raised as a query with HMRC, but the position is not yet clear.

What is clear is that sums a tenant has to pay in order to exercise a break clause to get out of a lease early will be a supply for VAT purposes.

Unusually, it appears that the new approach could apply retrospectively, so that any payment caught by it, and made in a VAT period that ends in the last four years, could be subjected to VAT after the event. Again, this is being queried with HMRC.

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