HMRC confirms change to VAT position when terminating an outsourcing or supply agreement for convenience
Termination for convenience
Outsourcing and other long-term supply agreements often contain termination for convenience provisions. These allow customers the option of exiting before the expiry of the full contractual term which is often 3 to 5 years and sometimes longer. This flexibility often comes at a cost to the customer in the form of early termination or cancellation fees.
These fees can address a range of costs to the supplier which are triggered by the early termination. Such costs may include break charges a supplier must pay to its subcontractors and providers; redundancy and other personnel related costs; sunk costs such as set-up and investments costs which have not been recovered through the service charges; and compensation of some or all of the profits which the supplier would have earned if the agreement had continued for its full contractual term.
Until recently HM Revenue & Customs’ position was that VAT was not generally chargeable on contractually-required early termination or cancellation fees paid by customers to withdraw from agreements for the supply of goods and services before the end of the contractual term.
However, following two cases in the European Court of Justice (Meo (C-295/17) and Vodafone Portugal (C-43/19)), HMRC has changed its position. As such, VAT will be payable on early termination and cancellation fees. HMRC says that this will be so even if the payments are described in the agreement as as compensation or damages.
Assessing the impact
HMRC’s guidance clarifies that early termination fees and cancellation payments are subject to VAT. Where both the customer and its supplier are registered for VAT and are fully taxable, the VAT will be recoverable as input tax. However, where the customer is not registered for VAT or is partially exempt, this will not be the case.
HMRC also advises those who previously failed to account for VAT on early termination and cancellation fees to do so. Further, anyone with a specific HMRC ruling that such fees are outside the scope of VAT should start to account for VAT with effect from 2 September 2020, the date of publication of the new guidance.
Tax partner Neal Todd says “Although it is to be welcomed that HMRC now accepts that its previous practice was not always in accordance with the law, taxpayers will be naturally concerned to understand the implications of the new approach. This is likely to require much greater scrutiny of contractual and other arrangements to determine whether there is a supply of goods or services – irrespective of the label used to describe those arrangements”.
If you would like to discuss this matter please contact the authors or your usual Fladgate contact.