Changes to VAT rules on compensation payments
On 2 September 2020, HMRC issued Revenue & Customs Brief 12 (2020) (“the Brief”), which updates their guidance on the VAT treatment of compensation and sums charged to withdraw from agreements early.
Although important questions are still outstanding as to the precise scope of the Brief, clients should consider carefully the VAT treatment of certain payments to be made under existing real estate contracts. The implications of the Brief should also be taken into account when drafting future contracts.
The change in policy summarised
The first two paragraphs of the Brief summarise the change in policy as follows:
“VAT is a tax on the supply of goods and services. Previous HMRC guidance said when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT.
Following the CJEU judgments in Meo (C-295/17) and most recently in Vodafone Portugal (C-43/19) it is evident that these charges are normally considered as being for the supply of goods or services for which the customer has been contracted for. Most early termination and cancellation fees are therefore liable for VAT. This is the case even if they are described as compensation or damages.”
In summary, therefore, certain payments previously regarded by HMRC as being outside the scope of VAT will now be treated as payments in respect of which the recipient will have to account for VAT.
As with other VAT-able payments, a recipient will be out of pocket if they are not contractually entitled to charge the payer an additional sum equal to the VAT, as they will be required to treat their receipt as a VAT inclusive sum and pay VAT out of the sum received. Although it is not yet completely clear how the Brief will impact real estate transactions, important questions arise in relation to:
- Break payments; and
Where the property in question is opted and the seller takes a deposit as agent, the seller makes a supply with the property and VAT must be accounted for. This contrasts with the situation where the seller takes a deposit as stakeholder, as no supply is made when the deposit is taken, so the seller has no obligation to account for VAT at that stage. Assuming the sale proceeds to completion, the stakeholder deposit is simply aggregated with the rest of the completion monies and the contract generally provides for VAT to be charged in addition to the total purchase consideration.
However, where a deposit was taken as stakeholder and the sale did not proceed to completion due to the seller’s breach of contract, the appropriation of the deposit by the seller was regarded as being outside the scope of VAT, as the deposit was damages for breach of contract. Following the Brief, this treatment is at least doubtful, and it may be that in cases where the buyer forfeits their deposit the seller will be obliged to issue the buyer with a VAT invoice and account to HMRC for VAT at the standard rate of 20%. For example, where a deposit of 10% was taken on consideration of 1,000 (i.e. a deposit of 100), if the deposit was forfeited, the seller would need to account to HMRC for 16.6 and retain only 83.4.
The Meo and Vodaphone Portugal cases mentioned in the Brief deal with mobile phone contracts where the subscriber terminated the contract early. The Brief does not specifically deal with real estate transactions and it may be possible to distinguish the situations dealt with in the Meo and Vodaphone Portugal cases, where a contract was terminated after performance was commenced, from forfeiture of a deposit where the payment was triggered by a failure to perform. However, in the rare cases where a deposit is forfeited, it is suggested that advice be taken in relation to the possible obligation to account for VAT. The possible impact of the Brief should also be considered when setting the level of deposit to be taken. As an illustration, using the numbers in the example above, if the seller wanted to ensure it could retain 100 if the buyer defaults, it would have to take a deposit of 120.
Previously, HMRC’s practice in relation to break payments was that these were taxable supplies where the payment was not provided for in the lease, but where the payment was provided for in the lease, the break payment was not payment for a supply. This was set out in their Supply and Consideration Manual (VATSC06720), as follows:
“There is no supply for VAT purposes of “the right to terminate” or other such services where a contract originally contains a clause allowing the parties to terminate early in lieu of compensation for perceived losses arising from the termination”.
Following the publication of the Brief, however, this guidance has been withdrawn and replaced with VATSC05920, which states:
“HMRC’s policy is to treat payments arising out of early contract termination as consideration for a taxable supply. Businesses must account for VAT on these fees. This applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached.”
In the case of break payments, therefore, there has been a clear change of policy. Where the lease in question provides for all payments to be made on a VAT exclusive basis, landlords should now issue the tenant with a VAT invoice and charge VAT in addition to the break payment.
The cases mentioned in the Brief deal with situations quite different from that of a tenant having to pay for dilapidations arising from physical damage caused to a property in breach of a lease. HMRC have not withdrawn their previous guidance on this point and although it will be necessary to review any new guidance as and when it is issued, it seems safe to assume for the moment that dilapidations payments are still outside the scope of VAT.
Water under the bridge?
The Brief represents a significant change in HMRC policy and VAT can be collected up to four years after it fell due. While it might be assumed that taxpayers should be able to rely on HMRC guidance in force at the relevant time, the Brief ends on a worrying note, stating simply, “Any taxable person that has failed to account for VAT to HMRC on such fees should correct the error”.
Many professional and industry bodies concerned with real estate have asked HMRC to clarify their position on retrospection and it is understood that HMRC are considering the issue. Further guidance can be anticipated, but it may be wise for those engaged in real estate transactions to consider what their potential exposure might be.
Clients should bear in mind that HMRC’s policy on the VAT treatment of cancellation payments has changed and the scope of their new policy is not yet completely clear. It will be necessary to monitor future HMRC’s guidance in this area, for example, in relation to retrospection, and take advice in cases of uncertainty.
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