This blog is a follow-up to our recent blog on HMRC’s surprising Changes to VAT and Early Termination Payments. As we noted, HMRC’s updated guidance is proving to be highly controversial.

What’s happened? Folks are unhappy because the updated guidance treats contract termination payments (including for breach or withdrawal or under liquidated damages clauses) as supplies for VAT (i.e. taxable), when they were previously treated as outside the scope of VAT.

Retrospective application. Even worse, the VAT changes operate on a retrospective basis. The retrospective nature of the change is inconsistent with the stance that HMRC normally takes when it amends its guidance, that changes are normally prospective not retrospective. HMRC has been the subject of heavy lobbying by a number of interested parties, particularly on the grounds that the retrospective nature of the change is contrary to established principles on legitimate expectations. HMRC is considering its position as a result.

Are all damages payments now subject to VAT? The change in HMRC’s guidance does not affect the general principle that a pure compensation or damages payment is outside the scope of VAT. VAT only relates to payments under a contractual term. In determining if a payment is compensation/damages, the exact purpose of the payment must be clearly established. If a payment is purely compensatory or a damages payment, it will be outside the scope of VAT. If, on the other hand, the recipient of the payment does something in return for this consideration, there will be a supply for VAT purposes.

Compensation/Damages or Consideration? Compensation has been described as reparation or restitution in respect of loss or damage. Only when a payment is unconnected to a supply of goods or services will a compensation or damages payment fall outside the scope of VAT. Whilst this may sound simple enough, it is rarely, if ever, clear cut! Parties should seek specific advice when unclear. A common area for confusion is in distinguishing between payments in respect of a failure to fulfill the terms of a contract, and a payment regarding the relinquishing of a right or benefit under a contract. The former is generally deemed not to be a supply for consideration, and hence outside the scope of VAT, and the latter is generally deemed to attract VAT.

What about IP infringements? Following the above, a payment received from a party for an infringement of intellectual property rights (such as copyright, trade marks, designs, or patents) will be outside the scope of VAT. In this instance, the payment is viewed purely to compensate the infringement of a person’s rights and therefore will not be treated as a consideration for supply. HMRC treats this principle as applying to damages awarded by a court within IP infringement proceedings and to out of court IP infringement settlements.

What about contract variations for IP licenses? However, a payment made to simply vary the terms of an IP license (e.g. to amend the territory or scope) or a payment made to terminate it early will attract VAT. These types of payment are treated as consideration in return for the contractual variation. HMRC will only consider these payments to be outside the scope of VAT if the parties can prove the payment was the result of a proper dispute created by the failure of a party to abide by the terms of the license.

Conclusion

A payment will be outside the scope of VAT if unconnected to a supply of goods or services. In order to determine this, parties must differentiate between a payment of compensation on the one hand, and a payment of consideration on the other. Any payment made within an IP infringement settlement must be structured as purely compensatory in order for VAT to be omitted. This must be taken into account when parties are drafting the terms of a license.

Written with support from trainees Moneek Chahal and Franki Scott.