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Home > Tax Articles > VAT & Excise Duties > There Is No VAT Due On Compensation Monies, But What Actually Counts As ‘Compensation’?
There Is No VAT Due On Compensation Monies, But What Actually Counts As ‘Compensation’? Print E-mail
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VAT Voice by Andrew Needham

Andrew Needham, Director of VAT Solutions (UK) Ltd, examines particular situations involving the payment of compensation. What constitutes a compensation payment and whether any VAT is due on it causes a lot of confusion to many people. The basic position is that compensation payments are outside the scope of VAT, as they are not the consideration for a supply. This is because the payments are made as a result of a Court Order, or through an agreement between the two parties involved to compensate the other for loss or inconvenience.

Early termination

Early termination of contracts has caused some of the greatest confusion in this area. In one case, two different Tribunals came to different conclusions on exactly the same facts. However, out of this confusion some clarity has arisen. HMRC now takes the view that there is no supply for VAT purposes of the “right to terminate” or other similar services, where a contract originally contains a clause allowing the parties to terminate early in lieu of compensation for losses arising from the termination. However there is a supply where no such rights exist, and agreements have been separately reached to terminate the agreement.

Agreements that allow for early termination will inevitably include related clauses that provide a formula for payment of compensation. These payments are often for loss of earnings and are known as liquidated damages. They are outside the scope of VAT. Lease arrangements for goods (rather than property) frequently include clauses that allow lessees to terminate early on payment of liquidated damages. No VAT is due on this amount. However, there is an agreement between the leasing industry and HMRC that allows them to charge VAT if they wish. In the event of a breach of contract, any compensation agreed between the parties is outside the scope of VAT.

Court settlements

Where disputes are settled through the Courts and they involve poor workmanship, prices charged, or poor standards, any settlement paid by the customer is additional consideration for the goods or services, and is subject to VAT. If interest is payable under the settlement, it is viewed as compensation and outside the scope of VAT. Where disputes involve libel or unauthorised use of trade names, payments are viewed as outside the scope of VAT. However, if in addition to the compensation payment, an additional payment is made to cover future use of a patent etc., it is taxable.

When goods are hired and a deposit is taken, if the goods are subsequently lost or damaged and the deposit is not refunded then this is also treated as compensation and is outside the scope of VAT. This would cover machine hire, for example a chain saw that is broken during its hire and the deposit withheld.

Land and property

There are a number of instances where payments between landlord and tenant are treated as compensation and, therefore, outside the scope of VAT. These include ‘mesne profits’, which are damages for wrongful occupation of the property, statutory compensation paid by a landlord to a tenant under the terms of the Landlord and Tenants Act 1995, and dilapidations paid to the landlord at the end of lease to rectify any damage to the property. The surrender of a lease or variation of a lease will follow the liability of the original lease, i.e. exempt unless the landlord has opted to tax. The reverse surrender of a lease, where the tenant pays the landlord to get out of an onerous lease, is also exempt unless the landlord has opted to tax.

March 2006

Andrew Needham
Director, VAT Solutions (UK) Ltd
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VAT Solutions (UK) Ltd
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VAT Solutions (UK) Limited is an established independent firm of Chartered Tax Advisers, formed by Andrew Needham and Steve Allen. The company has a cross-section of clients from multi-national companies through to medium-sized and numerous smaller regional firms of accountants and solicitors. They produce a regular publication 'VAT Voice', which can be downloaded directly from the Internet via their website:
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About The Author

Mark McLaughlin

Mark McLaughlin is TaxationWeb's Co-Founder, Director and Technical Editor. He is a Fellow of the Chartered Institute of Taxation and a member of the Association of Taxation Technicians and the Society of Trust and Estate Practitioners. He lectures on tax subjects, is co-author of Tottel's IHT Annual and Ray & McLaughlin's IHT Planning, and Editor of Tottel's Tax Planning and Annual series. Mark's work has also been published in Taxation, Tax Adviser, Tolley's Practical Tax, Tax Journal and Simon's Weekly Tax Intelligence.

Since January 1998, Mark has been a consultant in his own tax practice, Mark McLaughlin Associates, which provides tax consultancy and support services to professional firms. He publishes a regular 'Tax Update' e-Newsletter for clients and other professional firms. To receive future copies, contact Mark via his website.

Article Added Saturday, 22 April 2006 | 18352 Hits


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