HMRC have issued new VAT guidance in relation to termination fees and compensation payments. HMRC now consider that such payments will normally represent consideration for the supply of goods or services and therefore are liable to VAT. This results in uncertainty for many payments which would have previously been treated as compensation and outside the scope of VAT. We have considered the impact of the new guidance below, specifically in the context of M&A transactions.
HMRC new guidance
In September 2020, HMRC changed their guidance on early termination fees and compensation payments. Their previous guidance provided that compensatory payments were generally outside the scope of VAT. Payments made to withdraw from agreements and the payment of damages calculated according to provisions in a contract (so called ‘liquidated damages’ clauses) were treated by HMRC as being outside the scope of VAT.
However, HMRC now consider that termination fees and compensation payments will normally represent consideration for the supply of goods or services and therefore are liable to VAT.
This means that amounts paid to settle commercial disputes or terminate contracts – and potentially ‘break’ fees paid to abort M&A transactions – will all have to be considered carefully as to whether they constitute consideration for supplies liable to VAT.
HMRC rely on MEO and Vodafone Portugal. In those cases, the CJEU held that termination payments made before the end of an agreed minimum commitment period were an integral part of the price which the customer committed to pay to the provider for the underlying services. In other words, where a termination payment is agreed to be paid instead of the monthly payments for those services, that termination payment is treated as consideration paid in return for those services.
Questions to be asked
Following MEO and Vodafone Portugal, it seems to us that there are two important questions that parties have to ask themselves. Firstly, is the payment made instead of, or as a substitute for, the payments originally agreed by the parties to the (terminated) agreement? If the answer is yes, then it is likely the payment will be treated as an integral part of the price for the supply made under that original (terminated) contract. Secondly, it is important to understand the VAT liability of the supply made under that agreement. It is only if the original supply was liable to UK VAT that we would expect UK VAT to be chargeable in respect of termination or compensation payments.
Impact on M&A deals
In thinking about how we might answer these questions in practice, we have considered a case study of termination payments paid in the context of M&A transactions (i.e. a break fee).
If a seller pays a break fee to a bidder, this payment is not made instead of any other payment that the seller would have otherwise have been made to the bidder. So provided the payment is genuinely compensatory in nature and not a payment for a benefit (such as an inducement), we do not agree that this could be said to be consideration for any supply made by the bidder to the seller based on the MEO and Vodafone Portugal cases.
If a bidder pays a break fee to a seller, this may represent a payment made instead of the payments that would have been made to the seller. But even so, we remain unconvinced that VAT should be due on the break fee. In MEO and Vodafone Portugal, the underlying supply was of taxable telecommunication services, which meant that VAT was chargeable on additional payments made under those contracts. But in the case of break fees, if the M&A transaction had gone ahead it would have resulted in either an exempt supply (on the sale or shares) or an outside-the-scope supply (on the transfer of a business as a going concern). Either way, we do not consider that a break fee paid by the bidder in these circumstances should be liable to VAT, i.e. it is paid instead of a payment that would not have attracted VAT.
Are HMRC right?
Each payment needs to be considered on its merits. While it is no longer possible to rely on careful drafting (such as liquidated damages clauses) to justify a payment being outside the scope of VAT, it is key to understand the context in which the payment is made. If the payment is made instead of another payment that was originally promised under the (terminated) contract, then it is likely to be treated as an integral part of the price for a supply. But if a payment is not linked to the original supply under the (terminated) contract, there remains a prospect that the payment is outside the scope of VAT.
In addition, it is important to understand the VAT liability of the underlying supply. Is the underlying supply exempt from VAT? Is the underlying transaction a transfer of a business? Is the place of any supply outside of the UK? All of these questions will need to be considered carefully before concluding whether a payment is consideration for a taxable supply and chargeable to VAT.
HMRC’s previous guidance had the virtue of providing certainty. In essence, liquidated damages were treated as being compensatory and not liable to VAT. Now the position is more uncertain with a greater risk of VAT being charged.
For future commercial settlements and termination payments parties ought to consider who bears the VAT risk and clearly document whether payments are to made exclusive or inclusive of any VAT chargeable, with the payer having the right to a valid VAT invoice if the payment is liable to UK VAT.
It may also be helpful to explain the basis and rationale of the payment, because there may be scope to argue that the whole, or part, of a payment is not within the scope of VAT if it is not a substitute for the payments originally agreed by the parties under the (terminated) agreement relating to a taxable UK supply.
There is some suggestion that the VAT treatment of past payments need to be revisited, but it is not yet entirely clear whether HMRC will be looking to raise assessments for periods going back four years. We understand that retrospective application of the guidance would be on the basis that HMRC rely on cases that have declared (at least under legal theory) what the law has always been. However, if HMRC were to assess for periods prior to their new guidance, this could have an unfair impact on taxpayers who had acted in good faith based on HMRC’s previous guidance. Affected taxpayers will need to consider their potential remedies, such as judicial review or HMRC’s complaints procedure.