VAT Treatment of Early Termination Fees & Compensation Payments

In response to recent European litigation, HMRC has announced an important change in its policy relating to the VAT treatment of early termination fees and compensation payments, which may be viewed here.

The new policy is aimed at fees and payments charged where a contract for the supply of goods or services is terminated early, including early upgrade fees, liquidated damages and compensation for breach of contract. Previously, HMRC’s view was that, unless something was being supplied in return for the payment, it was normally outside the scope of VAT. They now regard such payments as being taxable.

Unusually, HMRC has instructed taxpayers affected by this change to correct VAT returns already submitted in accordance with its error correction procedures. The only exception to this is if HMRC has given a specific ruling that VAT is not chargeable, in which case VAT needs to be charged from 2 September 2020 onwards.  The issue of retrospection has been raised with HMRC.  Taxpayers should have a legitimate expectation that HMRC policy guidance ‘published to the world’ can be relied upon until the date of an announced change.  Whether HMRC will respond helpfully to these representations remains to be seen.  HMRC’s likely concern is that if it accepts that there should be no enforced retrospection there may be an asymmetric outcome, with taxpayers who will face additional liabilities will seek to rely on HMRC policy but the counter party to the transaction may insist on being allowed to reclaim VAT on the basis that this was contained within any payments made.

If you have received early termination fees, liquidated damages or similar compensation payments from your customers in the past four years and you have not accounted for VAT it is important to consider if this change applies to you.  Steps may be required to manage both the VAT position and the risk of penalties. The law stipulates that an error that was not careless when it arose is treated as careless (subject to a potential 30% penalty) if a taxpayer does not take ‘reasonable steps’ to inform HMRC after discovery.

In addition, customers who have made such payments may now be asked for backdated VAT from their suppliers. Whether the original payment agreed can be treated as inclusive of VAT may depend on the terms of the settlement, with the possibility that:

  • an additional amount will be payable; or
  • no additional sum will be due, and the customer can reclaim VAT from HMRC on the basis that the original payment was a VAT inclusive figure.

If this affects you and you need advice please get in touch with your usual Constable VAT contact or with Dean Carey at We will be pleased to advise you on your options and how best to manage any opportunities or risks this announcement presents.

This article is intended to give general guidance only and cannot be relied on in respect of any individual business. The facts may change as more information on the application of the reduced rate in particular circumstances is issued by HMRC. If you require advice specific to your business please contact Constable VAT or your usual adviser.