HMRC’s VAT policy on compensation payments confirmed

HMRC have updated their policy on early termination fees and other compensation payments. HMRC have confirmed that dilapidation payments following a lease termination and liquidated damages in construction contracts will remain outside the scope of VAT in most cases. However, most other payments are confirmed to be subject to VAT.

On 7 February 2022 HMRC issued Revenue and Customs Brief 2. This confirms that changes have been made to HMRC’s internal manuals which set out its guidance to its own officers on the VAT treatment of various compensation payments. Most of these payments are now seen as further consideration for a supply of goods or services, so will be subject to VAT.

When is this effective from?

Taxpayers must adopt the new guidance from no later than 1 April 2022 – this includes situations where a business is currently following a specific a ruling from HMRC that the compensation payments it received were outside the scope of VAT.

This follows the guidance published in September 2020, which was paused but had not been formally withdrawn. Most controversially, this earlier version suggested that dilapidations payments were effectively further payments of rent. Any business which treated payments it received as subject to VAT following this guidance, and which should have treated these as outside the scope, can now correct this.

What has changed since the previous version?

HMRC now accept that dilapidations at the end of a property lease will normally be outside the scope of VAT. This retains the existing policy set out in the Land and Property Public Notice. HMRC go into some detail on how they have come to this conclusion, discussing that there might be an exception made if they felt there was ‘value shifting’ of taxable rent charges to the dilapidations payment.

HMRC also confirm the VAT treatment of liquidated damages paid from supplier to customer has not changed. This was missing from the previous guidance. In a situation where a contractor is late completing a new building and a penalty clause is invoked, the payment from the supplier remains outside-the-scope of VAT. This is consistent with the policy set out in the Buildings and Construction Public Notice.

What is still taxable?

HMRC advise that in most other situations, compensation payments represent additional consideration for the goods and services supplies. This is the case regardless of whether they are described as ‘early termination fees’, ‘penalties, or ‘liquidated damages’.

Examples given of such payments are:

• liquidated damages paid by the customer to the supplier for terminating an equipment lease early
• early termination fees for a mobile phone contract
• penalty charge for returning a hire car later than agreed
• penalty charge for overstaying in a car parking space

In all these cases, HMRC expect there is a clear link between the payment made and the supply of goods and services that has been made.

Further information

We will be discussing HMRC’s updated guidance on dilapidations, as well as other payments between landlords and tenants, in a webinar on 22 March 2022. You can register here.

Please get in touch with Adam Cutler or your usual Crowe contact if you wish to discuss any of the above issues further.