VAT and Contract Termination Payments

Recently, our Tax Partner, Andrew Evans, wrote about the changes to the HMRC’s guidance on VAT and dilapidation payments when terminating a commercial lease. The revised guidance will take place from 1 April 2022.

This article sets out the position on paying VAT upon the termination of a commercial contract.

The position for commercial contracts is relatively straightforward. If the underlying contract was subject to VAT, a payment to end the contract early will (in most cases) also be subject to VAT. For example, a mobile phone contract or a car hire contract are subject to VAT. If you end the phone contract early, the termination payment will be subject to VAT as there is a direct link between the payment and the contract. The termination payment reflects what would have been paid under the original contract.

HMRC give an example where a payment will not be subject to VAT in relation to car hire. A car hire contract requires the hirer to return the car in one piece. Writing off the car is not anticipated at the time of the hire contract. Any payment for late return of the car will be subject to VAT, as it is directly linked to the hire. However, a charge in the event that the car is written off will not be subject to VAT. This is because the payment is not directly linked to the hire agreement, as the payment for the write off is not further consideration for the supply of the car on hire.

The above reflects the current approach taken by HMRC when considering court judgements for breach of contract. If there is a direct link to what would have been paid had the contract not have been breached, the compensation payment awarded by the court will be subject to VAT.

Should you have any queries in relation to whether you are required to pay VAT (or should charge VAT) for the termination of a commercial contract, please get in touch with Saima, who would be happy to assist.

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