VATSC05920 - Consideration: Compensation and liquidated damages that are consideration: Compensation payments: Early termination of contracts

HMRC’s policy is to treat payments arising out of early contract termination as further consideration for the contracted supply where the payments are linked to that supply, which will normally be the case. Businesses must account for VAT on these fees if the supply is taxable at the same rate of VAT as the supply. This applies in cases where the original contract allows for such a termination, as well as when a separate agreement is reached.

This is supported by the CJEU decision in MEO – C295/17, which concerned the treatment of early termination fees within contracts for telecommunication services. The Court held that the fact that there is a clause in the contract requiring the customer to pay an amount equivalent to the remaining fees, means the supplier is receiving further consideration for the original supply. The fact that the customer is no longer making use of that supply is not relevant if the supplier has made the service available.

The more recent case of Vodafone Portugal – C-43/19 endorsed that view, even where the amount payable is not equal to the amount that would have been due had the contract been fulfilled. The court said

“Article 2(1)(c) of Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax must be interpreted as meaning that amounts received by an economic operator in the event of early termination, for reasons specific to the customer, of a services contract requiring compliance with a tie-in period in exchange for granting that customer advantageous commercial conditions, must be considered to constitute the remuneration for a supply of services for consideration, within the meaning of that provision.”.

Early termination payments are also consideration for a supply when there is no pre-existing right to terminate in the original contract. The VAT tribunal judgment in Lloyds Bank plc (LON/95/2525) supports this. Lloyds sought an early termination of a lease it held on a property. The lease did not provide for such early cancellation. Lloyds and its landlord therefore agreed a variation to the lease, setting out terms for early termination and a sum to be paid to the landlord as compensation. The tribunal found that there had been a supply by the landlord of granting and exercising an option to terminate the lease in return for Lloyds making a payment and vacating the premises. As was found by the ECJ in Lubbock Fine C-63/92 where a lease is surrendered the liability of that supply will be exempt unless the tenant has opted to tax the property see VATLP02400.

Where the payments exceed the cost to the supplier of making the supply but are broadly equivalent to what the customer would have paid had the contract run as envisaged, they are consideration for the supply. The CJEU in MEO said -

“the predetermined amount received by an economic operator where a contract for the supply of services with a minimum commitment period is terminated early by its customer, or for a reason attributable to the customer, which corresponds to the amount that the operator would have received during that period in the absence of such termination … must be regarded as the remuneration for a supply of services for consideration and subject, as such, to VAT.”

Thus, payments that arise from a contract which is broken due to a cause attributable to the customer, being charged to cover the costs to the supplier of making the supply available, or equivalent to what would have been charged for the supply had it gone ahead as intended, will be further consideration for that supply.

Where an early termination fee is paid for terminating a contract that covers more than one supply, if it is not clear to which supply the termination payment relates, then a reasonable apportionment should be made in line with the guidance at VATVAL03000.