When two business entities end up in dispute regarding a supply made in the ordinary course of business, with the place of supply being in the UK, it is important for the parties to consider whether or not any settlement payment will be subject to VAT.  As parties continue to agree settlement terms following a force majeure event arising from the Covid-19 pandemic it is important to remember HMRC’s position on this which is considered in more detail below.

HMRC's position before 2 September 2020

Previous guidance said that when customers were charged to withdraw from agreements to receive goods or services, these charges were not generally considered to be ‘for a supply’ and were therefore outside the scope of VAT. Compensation for breach of contract was not subject to VAT as it was regarded as compensating for loss of profit rather than consideration for a supply.

Similarly, damages calculated according to provisions in a contract, such as liquidated damages, were taken to be compensation for loss of earnings and not subject to VAT.

On this basis, payments made relying on a force majeure clause, such as during the Covid-19 pandemic, would not have been regarded as VATable on the basis that there was no new supply of termination rights on which VAT could be charged.

HMRC's position from 2 September 2020

The basic position has been reversed with all termination payments being subject to VAT and the presumption now being that most compensation payments are subject to VAT unless an exception applies.

HMRC anticipates exceptions ‘only where there is no direct link between a payment and a supply of goods or services’ or where the payment relates to an exempt contract which was never subject to VAT.

As such liquidated damages and compensation which relates to a contract under which the paying party would have received a VATable benefit will remain subject to VAT.

Whilst the HMRC guidance does not deal with a situation where payments are made by the supplier rather than the customer, for example, as a penalty where works are not carried out by an agreed date etc, such payments will usually not be consideration for a supply and should therefore, depending on the circumstances, either be a repayment of some of the price paid by the customer, necessitating the issue of a VAT credit note, or be compensation which will remain out of the scope of VAT.

Summary

HMRC's change of view makes the task of assessing the VATability of most compensatory and termination payments easier but parties should consider the applicability of VAT prior to agreeing the terms of Settlement as it is likely to be too late to re-negotiate an extra 20% once any agreement has been reached.