VATSC05910 - Consideration: Compensation and liquidated damages that are consideration: When are compensation payments consideration for a supply?
Whether a payment is for a VAT supply depends on whether anything is being done in return for a consideration. Where a party agrees to do something in return for a fee there is a supply. How that fee is described does not affect whether there is a supply for VAT. What matters is whether something is done and if there is a direct link between what is done and the payment received, and reciprocity between the supplier and the customer (see VATSC05100).
The test of whether there is the necessary direct link between a supply and the consideration will already have been satisfied as regards a VAT-registered business’s normal income from a supply. Thus, the question will be, why isn’t other income it has received in connection with that supply also within the scope of VAT? To illustrate this point, as the Court of Appeal commented in paragraph 31 in Esporta Ltd v Revenue And Customs [2014] EWCA Civ 155:
“I cannot see how, as a matter of principle, and looking at the contract at the time it was made, the default provisions in the contract should affect the underlying analysis of the services that are to be provided in consideration for the fees. The default provisions are just that – steps that are taken when, unexpectedly, the member fails to comply with his payment obligations. They would not be expected to change the nature of the services that are to be supplied in consideration of the payments the member has agreed to make.”
Historically HMRC took the view that payments described as compensation were typically outside the scope of VAT. One authority for this was the CJEU case of Société thermale d’Eugénie-les-Bains (C-277/05). In the very particular circumstances of that case the Court concluded that the deposit received by the hotel was not a part payment for the accommodation, and when a customer cancelled a booking it was to be treated as outside the scope of VAT as it was compensation rather than consideration for a supply. In March 2019 we updated our guidance on deposits following later CJEU authorities, where the court found that similar payments were consideration – see VATSC05822.
More recent case law further indicates that some payments described as compensation or damages are nevertheless actually consideration for supplies.
In MEO – C295/17 the CJEU found that the fact that payments may be categorised as contractual penalties or compensation under national law was irrelevant to the question of whether there was a supply for consideration. In {#}Vodafone Portugal – C43/19 the Court confirmed that position saying:
“In the context of an economic approach, an operator determines the price for its service and monthly instalments, having regard to the costs of that service and the minimum contractual commitment period… …the amount payable in the event of early termination must be considered an integral part of the price which the customer committed to paying for the provider to fulfil its contractual obligations.”
For a payment to be consideration for a supply there needs to be reciprocity between the supplier and the customer. The supplier agrees to provide a service which the customer benefits from. An example of where the necessary reciprocity was absent is the case of Mohr v Finanzamt Bad Segeberg (Case C-215/94). In this case the German and Italian Governments argued there was a clear and direct link between payments made by state authorities to farmers to cease milk production. The court ruled that the payments were outside the scope of VAT. This was because the authorities were paying out money for a wider good. They did not directly benefit from the action taken by the farmer and so did not consume any service. The necessary reciprocity between the supplier and customer did not exist. There was therefore no supply, and so there was no consideration liable to VAT.
In Vodafone Portugal – C43/19 the test for whether a payment is consideration for a supply was summarised as follows -.
“31. A supply of services is carried out ‘for consideration’, …, only if there is a legal relationship between the provider of the service and the recipient pursuant to which there is reciprocal performance, the remuneration received by the provider of the service constituting the actual consideration for an identifiable service supplied to the recipient. That is the case if there is a direct link between the service supplied and the consideration received (judgment of 22 November 2018, MEO — Serviços de Comunicações e Multimédia, C 295/17, EU:C:2018:942, paragraph 39 and the case-law cited).
32.As regards the direct link between the service supplied to the recipient and the consideration actually received, the Court has held that the consideration for the price paid at the time of the signing of a contract for the supply of a service is formed by the right derived by the customer to benefit from the fulfilment of the obligations arising from that contract, irrespective of whether the customer uses that right. Thus, that supply is made by the supplier of services when it places the customer in a position to benefit from the supply, so that the existence of the abovementioned direct link is not affected by the fact that the customer does not avail himself or herself of that right (see, to that effect, judgment of 22 November 2018, MEO — Serviços de Comunicações e Multimédia, C295/17, EU:C:2018:942, paragraph 40 and the case-law cited).”
It is therefore essential that there is a direct link between the consideration and the supply. Where this is the case the supplier will normally have clearly agreed to do something for the customer in return for a payment. It may occasionally be the case that where an agreement does not explicitly allow a customer to do something the economic reality of the transaction is such that agreement to supply something is nevertheless effectively there. This may be when a similar amount is paid for the hire of something when it is kept beyond the agreed term to that paid for the agreed hire period. In the Tribunal case JG Leigh t/a Moor Lane Video. it was found that the economic reality was that the penalty charged for late return was an additional fee for hire.
Similarly, if a car is hired for a period of a week and is due to be returned by, say 9am on a Monday but is not in fact returned until 5pm on the following Tuesday a charge for late return will normally be made. Such charges are generally designed to both deter the person hiring the car from bringing it back late and to compensate the hire company for the additional use.
The charge will be subject to VAT as it is for the supply of the car, and the customer is aware that an additional charge will be made and how much that charge will be or how the charge will be calculated. Although the use goes beyond that which is agreed with the customer at the outset of the contract it is an additional hire fee similar to that in JG Leigh t/a Moor Lane Video.
If the customer were to write off the car and the supplier charges a fee for doing so this will not be further consideration for the hire of the car. The supplier does not agree that the customer can write the car off, and this is not something one would normally expect as part of the supply. The contract may envisage the possibility that the car will be written off and provide for a fee to be paid should that eventuality arise, but this is not further consideration for the supply as the necessary reciprocity does not exist.
Another potentially difficult area are dilapidation payments which occur in the land and property sector. These vary in the way they are provided for but broadly they exist to ensure landlords are not out of pocket if buildings are not returned in the agreed condition at the end of a lease. Our policy continues to be that these are normally outside the scope of VAT, see VAT Notice 742 Land and Property.
Again, the question that needs to be addressed is whether the payment is sufficiently linked to the supply of the lease to be regarded as further consideration for it. The service being supplied is the grant of an interest in the premises by way of a lease. It is the lease which creates the obligation to make such dilapidation payments. The obligation to make a dilapidation payment is not inevitable, rather the lease creates an obligation to return the property in the agreed state and it is the default on this obligation that gives rise to the requirement to make a dilapidation payment.
The tenant takes on a package of rights and obligations when entering the lease, one of which is to return the building in the agreed state. The rent will normally reflect those rights and obligations. If the tenant does not fulfil its obligation to return the building in the required state, it is required to make a further payment so the landlord can restore the building to the agreed condition, and it is in effect a re-imbursement of the cost of goods and services that the landlord faces incurring. It is arguable that this therefore represents additional consideration for the supply of the lease. If the obligation to return the building in the agreed state was not there it is probable that the rent would be set higher to allow the landlord to cover the costs of rectifying the building at the end of the contract.
On the other hand, if the tenant had exceeded the wear and tear that might reasonably be expected during the period of the lease, or even undertaken unapproved alterations, the dilapidation payment would be to rectify damage rather than for use of the premises and would be beyond what the landlord agreed the tenant could use the premises for. The link between payment and supply would therefore be broken. Although the payment arguably covers the landlord’s expenses in meeting the tenant’s obligation under the lease it may be difficult to establish that the rent has been set with that in mind. It may be that the rent in reality reflects what the market will bear and would not be increased if the dilapidation clauses were removed from the lease. In that case the dilapidation payment would be made to put right damage and there would not be sufficient link between the payment and the service(s) the landlord had agreed to provide under the lease. It would not therefore be further consideration for the lease.
Our policy having weighed these factors is not to treat dilapidation payments as further consideration for the supply of a lease. We might depart from that view if in individual cases we found evidence of value shifting from rent to dilapidation payment to avoid accounting for VAT.
Another example of a situation in which additional fees may be charged is parking. If the fee is for the additional use of the parking space it is further consideration for the supply of parking. HMRC’s policy position is that where a fine is substantial and punitive and is designed to deter a breach of the terms and conditions of parking it will be outside the scope of VAT as the reciprocity needed to link it to the supply is lacking. If on the other hand it is effectively an additional charge for occupying a space, then it would be a standard rated supply. The level of the fee for breaching the parking terms in comparison to the standard parking fee may be indicative of which category a particular fine would be in.
Officers may come across examples of charges where it is not clear cut whether they are directly linked to the supply. In which case they will have to make a judgement as to whether the charge is sufficiently linked to the supply or not, weighing the factors and the economic reality. If having analysed the paperwork and considered the economic reality they are unable to reach a conclusion, they should submit a TAR to VAT Advisory setting out the factors they think relevant to making the decision and their view.
Further guidance on certain types of payments can be found at:
- contract termination (VATSC05920),
- liquidated damages (VATSC05930),
- lease agreements for moveable goods (VATSC05930),
- breach of contract (VATSC05930).