Asset Finance: Change in VAT Treatment of Early Termination Payments
HMRC has confirmed that, in a significant change from its previous position, as from 1 February 2021 it will regard almost all payments made upon early termination of asset finance agreements as chargeable to VAT.
HMRC previously took the position that early termination payments were not sufficiently related to the provision of a taxable supply to be chargeable, so although by arrangement with HMRC it was open to financiers to apply VAT to early termination payments, usual practice within the industry of regarding such payments as outside the scope of VAT was accepted by HMRC.
However, in recent years there has been a series of judgments by the European Courts which have established that in principle early termination payments in asset finance are sufficiently related to the supply of a service to be chargeable to VAT.
Thus in case MEO – C295/17, which concerned the treatment of early termination fees within contracts for telecommunication services, the CJEU held that the fact that there is a clause in the contract requiring the customer to pay 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 irrelevant:
“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.”
So 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.
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”.
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 the new HMRC Guidance now says:
“Although the payments are designed to compensate, they are made as a result of events envisaged 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 will 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. HMRCs 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)”.
Breach of contract
The new Guidance also sets out HMRC’s views on breach of contract:
“It is also possible for leases and other agreements to terminate early if a particular event occurs such as the customer breaching the terms of the lessor. Where a contract ends as a result of an action by the customer that they could choose to avoid 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 payments are further consideration for the supply.(see VATSC05910)”.
It would therefore appear that most if not all payments due on early termination of an asset finance agreement will now be chargeable to VAT and should be treated accordingly by financiers.
When the issue was first raised by HMRC in September 2020, it was indicated that this new approach would be applied retrospectively, but following pressure from the FLA and others HMRC has now indicated that its change of practice will not be applied retrospectively, but only in relation to payments arising after 1 February 2021.
In terms of documentation, we advise financiers to check all existing Agreements carefully to see what if any provision they make in relation to VAT on early termination payments. Most Agreements are likely to be silent on the specific issue of charging VAT on early termination payments, and some will simply provide for VAT to be payable wherever chargeable, but there are likely to be a limited number of Agreements which may give rise to arguments that any VAT on early termination payments is not properly to be borne by the customer, so it is sensible for all Agreements to be reviewed to address this issue going forward.