On 2 September 2020, HMRC, issued a Brief dealing with the VAT on cancellation of a contract or early termination fees. The VAT treatment has changed for fees a business charges to allow customers to withdraw from agreements early. If your customer cancels an annual subscription part-way through a year and you charge cancellation fees what do you need to know?
Previously HMRC held that termination fees were generally not related to a taxable supply, and so were outside the scope of VAT. However, following two CJEU judgements HMRC has changed its view. Now, the position is that these charges are generally liable for VAT. VAT must be charged at the same rate as the related service. HMRC stresses that this is the case even if they are compensation or damages.
This issue is important for both suppliers and customers. A VAT charge will not be claimable as input tax by a business that makes exempt supplies, or is partially exempt. This policy change on VAT on cancellation fees is retrospective. So suppliers receiving compensation fees could be faced with a large assessment for VAT owed on past sales invoices.
Constance trades as an insurance broker and is dissatisfied with the services that her office cleaners provide at her premises. She cancels the contract and pays a termination fee equal to six months of cleaning fees to the supplier. HMRC now regards the charge by the cleaners as subject to VAT, even though no cleaning work will be done in return for this payment. This will be an extra cost to Constance because her insurance business is partially exempt and cannot fully claim input tax.
Despite the radical change of policy by HMRC, there will still be some compensation payments that will be outside the scope of VAT. For example, penalties and fines that are charged as a result of customer behaviour will still be VAT free in most cases.
Any taxable person that has failed to account for VAT to HMRC on such fees should correct the error. Any taxable person that has had a specific ruling from HMRC saying that such fees are outside the scope of VAT should account for VAT on such fees received from 2nd September 2020.
See the separate article for VAT on non-refundable deposits.
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