HMRC had for some time taken a somewhat arbitrary position in relation to the VAT liability of payments made by a party terminating a contract, such as a break fee under a lease. In their view, the treatment depended upon whether the termination provisions already existed under the contract (in which case, there would be no supply for VAT purposes) or had been agreed separately (in which case, the payment would be consideration for the "service" of the counterparty releasing the payer from the contract, and therefore potentially taxable).

This was widely regarded as being suspect and, following the decision of the CJEU in Vodafone Portugal (Case C-43/19), became unsustainable. And indeed, last week, Revenue and Customs Brief 12 (2020) confirmed that the distinction was no more and that henceforth all termination payments would potentially be subject to VAT.

However, HMRC did not stop at removing the distinction between extra-and intra-contractual termination provisions. They went on to revise their view of liquidated damages provisions generally, noting that: "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 are consideration for what is provided under it."

Previously, it had been their view (and the common understanding) that amounts that are genuinely compensatory in nature are not consideration for any supply and so are outside the scope of VAT. It is on that basis, for instance, that break fees under share purchase agreements (SPAs) are usually drafted as being a good faith estimate of the frustrated bidder's losses (e.g. costs and expenses wasted in pursuing the bid) and therefore liquidated damages to compenate for such loss - to make clear that they are compensation rather than, for instance, a contingent inducement payment (which would potentially be subject to VAT). But it seems that merely being compensatory in nature is no longer sufficient.

Does this mean that break fees in the M&A context will now attract VAT, at least where the seller is a UK entity (or the place of supply is otherwise in the UK)? We do not believe that this is necessarily the case. The focus of the analysis does, however, shift from the compensatory nature of the payment to the direction of the supplies and payments contemplated under the contract.

Where an agreement such as a mobile phone contract or a lease is terminated and the customer or tenant pays a break fee to the supplier, that payment is arguably a proxy for the future payments for taxable supplies that will not now occur – so it follows that it should be treated for VAT purposes in the same way as those payments would have been had the contract continued. Indeed, it is that sort of contract with which the decided cases and the guidance deal and arguably what the second sentence of the new guidance quoted above is getting at.

However, where a seller terminates a SPA and pays a break fee to the bidder, that payment - whatever it can be said to be - is clearly not a substitute for payments that would, but for the termination, have flowed to the bidder. Quite the opposite – if the SPA had run its course, then the supplies and payments thereunder would have run in the opposite direction. So the break fee would remain outside the scope, provided that it also satisfied the requirement of being compensatory in nature (i.e. not an inducement).

In other words, the rule of thumb would be to ask what would have happened had the (terminated) contract continued in effect. And if the answer is that there would have been taxable supplies made to the party paying the break fee, then such payment will likely be within the scope of VAT even if it is compensatory in nature.

....the rule of thumb would be to ask what would have happened had the (terminated) contract continued in effect.