VAT – Change to the treatment of early termination payments

HMRC recently issued a Revenue and Customs Brief (RCB) setting out changes to the VAT treatment of early termination payments. The guidance was given in the context of European Court decisions relating to the early termination of contracts for the provision of telecommunications services.  The RCB makes it clear that HMRC have changed their policy for all early termination payments.

  • This will be the case whether the payment is characterised as ‘compensation’ or ‘liquidated damages’.
  • The payment will be subject to VAT whether the payment was envisaged in the contract first signed for the provision of goods or services.
  • HMRC maintain that a payment made to a lessor for breach of contract will be subject to VAT.

A payment made in compensation for breach of contract will only be subject to VAT if the contract is terminated early as a result of the breach.

What does this mean for me?

Are you the supplier?

If you provide goods or services with payments due periodically over the life of a contract, you need to revisit existing agreements with your customers. If those contracts contain terms for early termination, liquidated damages or breach, those payments should be characterised as excluding VAT. This will protect the payment due on the basis that it excludes, rather than includes VAT. Similarly, any negotiated settlement not within the terms of your original agreement should exclude VAT.

This treatment will also apply to landlord and tenant relationships if you receive payment to break a lease early. However, it will not impact dilapidation payments, as these are not paid as a consequence of early termination.

Are you the customer?

If you are the customer, tenant, or lessee, you should ensure you understand the reason for making the payment. These changes only cover early termination, which is particularly relevant for payments due for breach of contract. If the contract is not terminated early as a result of the breach, the payment is not subject to VAT.

If VAT is due, make sure your supplier provides you with a valid VAT invoice, so that you can recover VAT on your next VAT return.

What about the historical position?

HMRC have stated that they expect businesses to review the position taken over the last four years and adjust the position if payments have been received and VAT has not been paid to HMRC. They have stated a ruling from HMRC is not sufficient defence against the need to pay VAT on amounts previously received by the business. This is an unwelcome, but not unprecedented position taken by HMRC.

If this is an issue for you as a supplier, please speak to us as there may well be a defence available on the grounds of the legitimate expectation of following clear and unambiguous guidance from HMRC.

If you would like to discuss this further please get in touch with indirect tax partner Jonathan Main on 01772 821 021 or