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VAT on damages and contract terminations

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What constitutes a compensation payment and whether any VAT is due on it can cause a lot of confusion for commercial negotiators. Whilst as a general rule, compensatory payments are outside the scope of VAT (as they are not the consideration for a supply), in the commercial world the exceptions relating to past and future VATable supplies can often apply. Further issues to look out for relate to the set-off of settlement payments and whether anything is being supplied in relation to a termination payment under a contract.

This article discusses VAT issues that commonly arise on settlements of disputes and terminations of contracts. The coronavirus pandemic is being felt across all sectors, leading to cost cutting in the form of releasing obligations under contracts and settling legal disputes. Each of these actions can lead to unintended VAT consequences if not carefully managed.

It does not, however, discuss court settlements. Since the establishment of the Gourley principle in British Transport Commission v Gourley [1956] AC 185, courts have been keenly aware of and can factor in the effect of tax on awards of damages when they calculate the claimant’s loss. Discussion of the principle, its pitfalls and limitations, would be an article in itself and we will not discuss it further here.

VAT: why it matters and why it can be confusing

Standard rated VAT in the UK is (ignoring Covid-19 related dispensations) currently 20%. Establishing whether an extra 20% is due on a payment can affect the viability of the commercial decision underlying the amount of that payment for the payor. This is particularly the case with businesses in VAT exempt sectors such as financial services, where VAT recoverability is limited or non-existent. Similarly, a payee will want to make sure it is obtaining that extra 20% where it has to account for VAT to HMRC in respect of the payment.

However, for something we encounter daily in commercial life, VAT can be complicated and fraught with uncertainty and this is nowhere clearer than in the field of out of court settlements.

This difficulty is perhaps best illustrated by looking at how the courts can struggle with it. In the separate cases of Holiday Inns (UK) Ltd [1993] VAT Decision 10907 and Croydon Hotel & Leisure Company Ltd [1997] VAT Decision 14920, VAT tribunals reached opposite conclusions on the same fact pattern around a contract termination payment. The first tribunal ruled that the termination was a variation of the original contract and consequently the payment was not VATable for Holiday Inns and no output tax was due. The second tribunal decided that the termination agreement supplied a VATable right to terminate to Croydon Hotel, so input tax was claimable (but by then it was too late for HMRC to go back to Holiday Inns for the output tax). These two cases illustrate the difficulties around contract terminations, but the crux of the matter is the same for other types of settlement payment: has a taxable supply occurred or not?

The basic position on settlement payments

HMRC originally treated settlement payments as VATable (for giving up a right to sue in exchange for payment), but it has long since confirmed (in VAT Supply and Consideration Manual at VATSC06832 and VATSC06833) that compensation for breach of contract is compensating for loss of profit rather than consideration for a supply (and therefore not VATable). Similarly, damages calculated according to provisions in a contract, such as liquidated damages commonly found in construction contracts, for example, are taken to be non-VATable compensation for loss of earnings. This is the basic position. However, there are several exceptions; the two main ones that are relevant to many commercial scenarios are where:

  • the claim relates to a payment that was withheld for VATable goods or services; or
  • the payment is for a future supply of VATable goods or services.
Past supplies

If a claim relates to money withheld under a contract, and the original invoiced services were VATable services, VAT is due on any money paid in settlement of this claim. This is because the settlement payment is (part) consideration for the original supply, even if you call it compensation, and the parties will then have to sort out their input and output tax (and any bad debt relief) accordingly.

Future supplies

Settlement agreements can range in scope. Many allow for certain aspects of the original commercial agreement between the parties to continue. For example, a settlement agreement can provide for continued use of intellectual property previously shared between the parties. In instances such as these, if the ‘supply’ made pursuant to such provisions is a taxable supply, a settlement payment made under the agreement will attract VAT as it constitutes consideration for such a supply.

Is it a UK B2B supply?

We are, of course, assuming above that the counterparties are both business entities and both in the UK. When deciding the VAT treatment of a payment, one should start from first principles and it is important to always ask:

  • Where is the place of supply? If it is not the UK, UK VAT is not relevant. The usual rules apply here, so if, for example, a German car parts manufacturer is paying a settlement sum to a UK car brand for defective parts in cars sold in the US, the place of supply (if any) is Germany and it is German (not UK or US) VAT law which is in play.
  • Is the supply made in the course of a business? For corporates in a commercial dispute, the answer is usually yes. But if, for example, a charity or individuals are involved, or the matter is personal to the parties, the answer may be different.

The contract is king

It would be nice if one could simply describe payments in settlement agreements as compensation so that they do not attract VAT, and be done with it. Unfortunately, that is not the case. In Meo - Serviços de Comunicações e Multimédia (Case C-295/17), the CJEU confirmed that VAT was due despite the payment consistently being described as ‘compensation’ in the contract.

Courts look at the intention of the parties involved, as evidenced by the terms of the original contract. So, where a claim involves a contract under which VATable supplies were previously made, how the contract operates is paramount.

Example: A construction contract is subject to VAT and the contractor is seeking an amount for cost overruns due to delayed completion. You get two different results, depending on the terms of the original contract:

  • The claim is made under a specific compensatory events clause, which is a separate contractual mechanism to the consideration clause for the primary (VATable) supply. Whilst the clause was drafted so that amounts payable for compensatory events are calculated by reference to additional project costs incurred, it is clear that the payment is compensatory damages for the event’s occurrence and therefore outside the scope of VAT.
  • By contrast, if the construction contract provided for project cost overruns incurred by the contractor in relation to certain events to be recharged or accounted for on an as-incurred basis then the settlement payment would more likely be further (VATable) consideration for the original supply provided under the contract, as it would constitute an effective (if delayed) on-charge of costs incurred in the course of the original supply.


What happens if there are counter claims folded into the settlement? Unfortunately, VAT cannot be negated by setting-off payments against each other. If a settlement agreement explicitly caters for the settlement of a claim X and counterclaim Y where Y is VATable but X is not, you cannot deduct Y from X and say the sum is not VATable.

HMRC is clear (in VAT Notice 708, at para 22.3) that set-off does not eliminate a supply, even if it eliminates the payment in respect of that supply: there remains two supplies going in opposite directions, and you have to account for the VAT on amount Y.

However, wording a settlement agreement by stating a global figure paid in one direction comprises a settlement of all claims can avoid this issue (as there is then no set-off at all).

Blurred lines

There is a similar problem if the settlement is made in respect of multiple claims. For example, our contractor may receive a global sum compensating for lost earnings (not VATable), outstanding invoices (VATable past services) and the completion of further works (VATable future services).

The mixing of VATable and non-VATable supplies within a single payment can muddy the waters. It might be tempting to cram the whole sum into ‘compensation’, but it is best practice to clearly split out and spell out the VATable and non-VATable elements of the settlement sum. Otherwise, there is a risk HMRC may see the whole payment as a single (most likely, VATable) composite supply.

A right to terminate?

Settlement payments can, of course, also be made on termination of obligations under a contract. A deluge of case law in this area has led to HMRC holding that a ‘right to terminate’ can be supplied in exchange for a termination payment. This VATable supply overrides the basic rule set out above that compensation payments are not subject to VAT.

Has a ‘right to terminate’ been supplied? The key point here is whether the payment is made pursuant to the terms of the original contract.

If it is (for example, relying on a force majeure clause during the current Covid-19 pandemic), then there is no new supply of termination rights on which VAT can be charged (though the payment may still be VATable for other reasons; for example, if it is final payment for services rendered).

If it is not, then the separate termination agreement concluded at the time of termination indicates, by contrast, that the payment is in exchange for a VATable ‘right to terminate’.

Four magic words

For both parties (but particularly the payee), it is important to insert the words ‘plus VAT if applicable’ into the settlement agreement. This is because:

  • it encourages everyone to pause and consider the treatment, flushing out latent VAT issues; and
  • it ensures the commercial negotiators have brought the issue to the table and have not forgotten to raise it before they agree a sum.

Remember, a silent contract is a VAT inclusive contract, and it is too late for the payee to go back for that extra 20% once the agreement is signed. This is especially true in scenarios where there is extra VAT compliance involved. For example, when the sum is a refund and triggers a credit note and unwind of excess input and output tax, everyone needs to be in agreement before the payor approaches HMRC for an output tax repayment.

Points to bear in mind

It is important to get the VAT treatment right in the settlement agreement itself, by answering these questions:

  • Do you expect VAT to be charged?
  • How will any proposed drafting impact VAT recoverability?
  • Who do you expect to bear the cost of any irrecoverable VAT?
  • Is there any compliance that the other side must undertake (e.g. issuing invoices or credit notes)?

Applying first principles and assessing the terms of the sued-upon contract as a starting point can usually address many of the potential issues outlined above.

It is unclear contract wording that causes the most problems, so getting the drafting right in the original contract in the first place (by including termination rights, or clear wording outlining compensation payments on a default) can go a long way to helping sort out the analysis when any payment is later made. 


Since this article was first published, HMRC issued Revenue & Customs Brief 12/2020 on 2 September 2020 changing its policy on the VAT treatment of early termination fees and compensation payments.

Previous HMRC guidance said when customers are charged to withdraw from agreements to receive goods or services, these charges were not generally for a supply and were outside the scope of VAT. It was thought that the Meo (C-295/17) and Vodafone Portugal (C-43/19) cases were limited exceptions to that general rule.

However, HMRC now interprets the cases to set a new general rule that UK VAT is payable on early contract termination and cancellation fees, and extend this to compensation payments.

This addendum focuses on the practical effects of HMRC’s new guidance in its VAT Supply and Consideration Manual at VATSC05910, VATSC05920 and VATSC05930. A subsequent article on this topic will be published in due course.

The basic position (revisited)

The basic position, therefore, has been reversed. The presumption should now be that most compensation payments are VAT-able unless an exception applies.

Exceptions will be hard to find in contractual disputes, given HMRC (at VATSC05910) anticipate them ‘only where there is no direct link between a payment and a supply of goods or services’.

Liquidated damages clauses exist as a result of events envisaged under the contract. So, in HMRC’s view, they form further consideration for what is provided under it, as just another integral part of the price which the customer committed to paying.

Consequently, provided the compensation payment relates to a contract under which the payer had or will receive a VATable benefit in the first place, VAT will be payable. But a compensation payment relating to an exempt contract, should presumably remain exempt from VAT.

Termination payments

Termination payments outside the original contract were already VATable, and previously, assessing VATability involved judging whether a new VATable ‘right to terminate’ had been supplied or not.

What is new is that all termination payments (whether set in the original contract or not) are now VATable (see HMRC’s revised guidance at VATSC05920).

What remains uncertain however is what happens when you terminate a contract making exempt supplies. If it is paid within the original contract, then logically per Meo and Vodafone Portugal it should be exempt – but the guidance is silent on this.

Still standing

Although the guidance remains unclear, these changes do make the task of assessing the VATability of most compensatory and termination payments easier. For example, issues from mixing VATable and non-VATable supplies within one payment will not often arise because there will simply be few non-VATable payments arising.

However, some points to consider do endure and should continue to be applied in this context:

  • The place of supply and whether the parties are in business still needs analysis. Only a supply between businesses where the place of supply is the UK will attract UK VAT.
  • VAT cannot be negated or eliminated by set-off. The position remains that VAT has to be accounted for on the full amount of both supplies going in either direction.
  • Drafting a VAT clause (inclusive or exclusive) remains key. It is important to understand the commercial position of who is to bear the VAT that will now normally be due on a settlement or termination.