Fabian Barth explores the circumstances when businesses need to account for VAT on compensation payments received from customers.
In business, not all interactions with customers go as intended. Where legal rights are violated, one may successfully claim damages or other forms of compensation. The question then arises: do I need to account for VAT when receiving such payments?
The same issue has kept the courts busy for decades. Most recently, the Court of Justice of the European Union (CJEU) has added the latest chapter to the saga with its judgment in the case RHTB CJEU (C622/23) [2024]. Since CJEU judgments are still highly persuasive in UK VAT, where does that leave the law at present?
Categories of compensation
In general, any ‘compensation’ payment could be subject to VAT if it was consideration for a supply of goods or services. The general mantra employed by the courts is that one ought to affirm the existence of such a supply if the payment is (legally or contractually) contingent upon the provision of something and viceversa.
Thus, the first question to ask in any given case is whether the compensation is in any way related to a contract between payor and payee (e.g., compensation paid by a customer in relation to an order they cancelled).
In one bucket are instances where the compensation has nothing to do with any contract the parties may have (e.g., A and B have a contract over the sale of corn; unrelatedly, A happens to damage B’s car when reversing in the parking lot). For completeness, the same category would cover the (much rarer) claims in restitution (for unjust enrichment or noncontractual performance), too.
If the compensation is related to a contract however, a further distinction has to be made:
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The customer agrees to buy something but then chooses not to receive the good or service (e.g., they reject goods; they buy cinema tickets and then do not attend). VAT becomes relevant if the supplier still receives or retains some payment (e.g., because a nonrefundable fee was agreed).
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A party must pay compensation because they do something they are not supposed to do under the contractual terms. For example, someone returns hired goods later than agreed.
In summary:
Scenario 1: No (relevant) contract at all
Damages that are due only as a result of a tort are definitely outside the scope of VAT. They are not consideration for a supply because the innocent party never agreed to anything – they would rather have the tortfeasor do nothing at all. Accordingly, in the example where A causes damage to B’s car when reversing in the parking lot, the damages paid to B are outside the scope of VAT, not consideration for any supply B made to A.
The same logic can perhaps be transposed for arguing that no VAT is due on successful claims in restitution, but this is untested in court.
Scenario 2A: Customer pays for (agreed) performance
The general thrust of the case law is that where a supply of services has been agreed, VAT will be due on any payments in relation to these services. This is the case whether or not the customer availed themselves of the rights and benefits from the service: the courts have broadly held that it is the right to receive the service which constitutes the supply, not the actual performance of the service.
Accordingly, where an airline sells a flight ticket and is ready to transport a passenger, the latter receives a service even if they do not show up for the flight (Air France-KLM CJEU (C-250/14) [2015]). It is not even necessary that the supplier is actually ready to provide the service. It is sufficient that they would have been ready had the customer not repudiated the contract. Therefore, if a hotel knows in advance that the traveller is not making use of their booking (so that they will probably not prepare the room), any retained fee is still consideration for the same supply of services as if the traveller had stayed in the hotel (Blue Lagoon Beach Hotel v Assessment Review Committee & Anor (Mauritius) [2023] UKPC 24).
The position is less clear for a contract for goods. Common sense points to there not being a supply of goods where goods are never delivered (because the order is cancelled) or rejected and returned. But where the supply was or would have been accompanied by an ancillary service (delivering the goods, for instance, is already such a service element), any monies paid or retained by the customer can still be consideration therefore, and thus subject to VAT (ASOS plc v Revenue and Customs [2018] UKFTT 353 (TC)). But that service may be subject to a different VAT treatment (e.g., different place of supply) than the original supply of goods may have been.
VAT is due only on the monies received by the supplier. But it is irrelevant how that amount is calculated. If a contract stipulates that the customer needs to pay the full price even if they withdraw before performance, then VAT is generally due on the full amount. However, it makes no difference if the contract stipulates a different amount, e.g., a provision allowing the customer to be released early from a fixed term contract for a ‘cancellation fee’ is still consideration for the service under this contract (and thus subject to VAT) (Vodafone Portugal CJEU (C43/19)).
If the contract does not make provision for what happens in case of customer withdrawal, an English court would normally award the supplier damages that put him in the same position as if the contract had been performed (called ‘expectation loss’ in contract law; usually such damages are the agreed price less supplier’s saved expenses). Last year, in the judgment RHTB, the CJEU equated damages for such ‘expectation loss’ to contractually agreed amounts. It is thus now clear that they are subject to VAT in the same manner.
In a nutshell, any payment received for an agreed supply is likely subject to VAT. The VAT law is (at least for services) indifferent as to whether it actually happens, and how any compensation payment is calculated if performance does not occur.
Scenario 2B: Contract stipulates payment for breach
Leaving aside customers’ rejection of a supply, a contract may sometimes also, for other breaches, specify an amount that the party committing a particular breach must pay to the innocent party (e.g., a fixed perday fee is agreed in a contract for the hire of goods if they are returned too late). Contract law calls these ‘liquidated damages’. In theory, liquated damages are not different from any other damages and, hence, outside the scope of VAT. The difficulty is that liquified damages are, in practice, very hard to distinguish from normal contractual offers.
Take for instance, the case of a private car park where one can buy a ticket which is valid for a fixed time. It clearly displays: ‘If you overstay, we will charge you £50’. On one view, this could be intended to say: ‘We really want you to vacate the lot on expiry, but if you breach that, compensation for the unauthorised use of our land is £50’. These would be liquidated damages, so no VAT would be due. On the other hand, one could look at it as a simple contractual offer: ‘You can stay longer for the price of £50’. This would be a taxable service.
The distinction can thus turn on very fine details. The Court of Appeal confirmed damages in a specific case because the parking operator reserved a right to tow the vehicle (Vehicle Control Services Ltd v Revenue and Customs [2013] EWCA Civ 186), which meant those who stayed longer became trespassers. In a very similar case (except that there was no right to tow), the CJEU has looked at the arrangement as a normal contractual agreement and held that VAT was due (Apcoa Parking CJEU (C90/20)).
HMRC considers the amount of the payment to be of relevance (the higher it is, the more likely it is meant as a deterrent and thus damages). But in practice, a business should be able to point to a range of additional factors if they really consider compensation as damages for a breach: clear contractual language and other communication to that effect; strict enforcement of breaches; a general compliance of customers with the obligation. Otherwise, it is prudent to charge VAT.
Summary
Practical tip
The scope of compensation payments on which no VAT is due is increasingly narrow. Where a customer simply compensates you for cancelling or rejecting a supply, you virtually always need to pay VAT on it. For other damages, the waters are muddier and not paying VAT is often defensible.
