HMRC has issued an important update on the VAT treatment of compensation and similar payments.

Supplies, defined as compensation or early termination fees are now considered to be liable to VAT. An example would be charges made when exiting one mobile phone contract and entering into another to upgrade a package.

HMRC will now treat these supplies arising out of early contract termination, as a consideration for a taxable supply, and consequently subject to VAT.

Why has this changed?

According to previous HMRC guidance, charges applying to the withdrawal from agreements, such as mobile phone packages referred to above, were not considered for supply, and were therefore outside the scope of VAT.

Following recent judgments of the Court of Justice of the European Union (CJEU), these charges are now considered to be the supply of goods or services, meaning most early termination and cancellation fees are now liable for VAT.

This also applies if the charges are described as compensation or damages.

What does this mean?

HMRC advise that anyone who has failed to account for VAT on such supplies in the previous 4 years should correct the error. This retrospective action seems to be very harsh.

Apart from correcting previous errors the new VAT treatment should be applied from 2 September 2020, unless a specific ruling has been obtained from HMRC to state that the fees are outside the scope of VAT.

Therefore, any payments that have previously been treated as outside the scope of VAT compensation should be reviewed.

For further clarification, or guidance on correcting VAT errors, please get in touch with our VAT experts, who will be happy to assist.