On 2 September 2020 the UK issued Revenue and Customs Brief 12 (2020) in relation to VAT on early termination fees and compensation payments.

The previous guidance was that payments charged to withdraw from agreements to receive goods or services were outside the scope of VAT because these were not payments for a supply.

HMRC has however changed its advice further to the judgments of the European Court of Justice (ECJ) in the MEO and Vodafone Portugal cases.

The view of the ECJ in those cases was that they were made for the supply of goods or services that the customer had contracted for. Consequently early termination and cancellation fees are generally within the scope of VAT, even if they are described as compensation or damages.

Payments within the scope of VAT

HMRC notes that a payment is for a VAT supply if something is done in return for the consideration. If a party agrees to do something in return for a fee there is a supply for VAT purposes, regardless of how that fee is described. The important point is that there is a direct link between what is done by the supplier and the payment received.

An example given by HMRC is the charges made when a customer ends one contract and concludes another for the purpose of upgrading a mobile telephone package or handset. This would now be regarded as a payment for a supply and would be liable for VAT.

The ECJ noted in the Vodafone Portugal case that an operator decides on the price for its service and monthly instalments taking into account the costs of the service and the minimum contractual commitment period. The amount payable for early termination of a contract should be considered as an integral part of the price the customer is committed to paying for the provider to fulfil its contractual obligations.

In the MEO case the ECJ found that even if payments were categorised as contractual penalties or compensation under the national law this was not relevant to the issue of whether there was a supply made for consideration.

Payments outside the scope of VAT

A payment is only outside the scope of VAT if there is no direct link between a payment and a supply of goods or services. HMRC gives the example of Mohr v Finanzamt Bad Segeberg where case the German and Italian Governments argued there was a clear and direct link in the case of payments made by state authorities to farmers to cease milk production. The ECJ ruled in that case that the payments were outside the scope of VAT because the government authorities did not directly benefit from the action taken by the farmers and so did not consume any service. There was no supply, and therefore no consideration liable to VAT.