New rules on termination fees and compensation payments

April 13th 2022

Your business has mobile phone contracts and hires vehicles for employee business trips. How do you check that you are not being overcharged VAT following HMRC’s change of rules on termination fees and compensation payments? VAT expert John Craig takes a closer look.

New legislation for early termination fees and compensation payments took effect on 1 April 2022. The basic principle of the change is that VAT will be payable on the fees you pay for terminating contracts early if the payments within the original contract were taxable, for example, hiring a car is a taxable supply, so a fee you pay for returning the car early would also be taxable.

Your business took out a three-year mobile phone contract in 2020 paying £1,000 per month plus VAT. You want to cancel the contract early because you’d like a different type of phone for your staff. The current supplier has agreed that you can pay a one-off fee of £10,000 to cancel the contract early. This fee will be subject to VAT from 1 April 2022, as it is classed as an extra payment for the supply of the phones. You will pay £12,000 including VAT.

The key issue here is that the supplier has agreed to do something for you in return for this payment of £10,000, i.e., cancel the contract. And because the original contract related to a taxable supply of services, the extra payment will be subject to the same rate of VAT.

If your business is partly exempt or exempt, this VAT charge will be a cost to your business because you cannot fully reclaim input tax on your expenses.

Sales invoices
HMRC’s guidance makes it clear that the way that sales invoices are described is irrelevant. The key issue is what is being done by your supplier in return for the payment. The guidance refers to “reciprocity between the supplier and customer”. So, just describing a sales invoice as a compensation payment or payment for damages does not alter the VAT position.

If you are being charged VAT by your supplier, you need to ask if you are getting any benefit in return for this payment? For example, if your business hires a car and you return it to the hire company with a dent in it, and you are charged a damage fee, this is outside the scope of VAT because you are not receiving any benefit for this payment.

In situations like the car damage, don’t accept a VAT charge from your supplier if it is incorrect, even if they give you a tax invoice. You can only claim input tax if VAT has been correctly charged.

Dilapidation payments
HMRC originally intended to treat dilapidation payments as being subject to VAT. They have now decided that this will not be the case, which is welcome. A dilapidation payment is paid by a tenant to their landlord at the end of a lease, to compensate the landlord for any repair work that is needed. Any dilapidation payments you make or receive are still outside the scope of VAT.
You should challenge your landlord if they try to charge you VAT on dilapidation payments.

Check if you are getting a benefit from your supplier for your termination payment. If so, and the original contract was taxable, the termination fee will also be subject to VAT. But VAT will not be charged on many compensation payments, such as dilapidation payments at the end of a lease.