VATSC05930 - Consideration: Compensation and liquidated damages that are consideration: Liquidated damages

Agreements that allow for early termination will invariably include related clauses that provide a formula for payment of compensation in the event of such termination. These amounts are generally expressed as being compensation for loss of earnings and are often referred to as liquidated damages. In the light of MEO and Vodafone Portugal these need to be considered carefully to determine whether they are consideration for supplies (see VATSC05910 and VATSC05920).

Although the payments are partly designed to compensate, they are made as a result of events provided for under the contract. They are therefore part of the agreement, and if they form costs to the supplier of making the supply available or equate to what would have been charged for the supply had it run as expected they may be further consideration for the supply. Lease agreements for moveable goods commonly include clauses that allow lessees to terminate early but to pay liquidated damages as a result. Examples of this are vehicle finance leases that customers can cancel after an initial period of hire but, if so doing, must pay a termination fee to cover the loss of future rents. HMRC’s previous guidance suggested these were outside the scope of VAT but under an agreement with the leasing industry allowed lessors to treat lease terminations as taxable supplies if they so wished. The CJEU judgments in Vodafone Portugal and MEO make clear that such payments are taxable and must be treated as such (see VATSC05910 and VATSC05930).

Where a supplier makes a supply available to a customer, but they do not avail themselves of all or part of that supply, and the supplier charges a payment to compensate them for having made the supply available that will normally be further consideration for that supply. That is the case even if it is described as damages (see VATSC09520).

If a customer uses less of a supply than they contracted and does not pay the amount agreed for the supply in the contract, but is instead charged another fee to compensate the supplier for loss of earnings this will normally be consideration for the original supply however it is described, as that is the economic reality if the supplier has made the supply available. If however that fee is at a level such that it is clearly punitive and is designed to prevent breach rather than to compensate for lost income, then the link between that payment and the supply is not sufficient to regard it as additional consideration, and it will be outside the scope of VAT. Operational colleagues will need to apply their judgment to the facts of their case and should seek assistance if necessary via a Technical Advice Request.

It is also possible for leases and other agreements to terminate early if a particular event occurs such as the customer breaching the terms set by a lessor. Where a contract ends as a result of an action by the customer which causes the supplier to terminate the lease, then if the supplier charges a fee to cover the costs of making the supply, or an additional fee broadly equivalent to what would have been charged under the contract had it run as envisaged, then the payment is further consideration for the supply.(see VATSC05910).

Where a supplier breaches the terms of a contract, rather than the customer doing so, then they may reduce the price they charge for the supply, as what is being supplied has been altered. This will result in less VAT being charged if the supply is taxable. If the adjustment is made retrospectively the supplier must adjust the VAT they have accounted for under VAT Regulation 38. Price adjustment in these circumstances are common practice and if the customer is asked to pay less it is likely that in economic reality the price has been reduced to reflect the lower value of what was actually provided. If the price is not adjusted, but the supplier agrees to pay liquidated damages to compensate the customer for the actual loss suffered as a result of the breach the payment will be outside the scope of VAT. This might happen where the knock-on effect of the supplier not fulfilling the supply as originally agreed result in substantive costs to the customer for which they seek recompense. The payment may bear little relation to what was provided and if this is the case the payment will not be sufficiently linked to the supply to be treated as reduced consideration.

The case law in this area may continue to evolve, if officers come across borderline cases they should seek advice by submitting a TAR to VAT Advisory Team in accordance with VPOLADV.