When is compensation subject to VAT?

When compensation is received, is VAT chargeable?

This might seem like an odd question.  After all, if someone receives compensation from their employer for an injury in the workplace, that would not be subject to VAT.

In fact, there are many scenarios in which compensation is considered to represent payment for supplies.  However, it is not always clear that a supply has been made in many instances and, in particular, those preparing contracts or handling negotiations in the event of a breach of contract should always take note of the potential VAT issues.

We reported an example of these issues on 25 October 2011 in the First-tier Tribunal case of Esporta Ltd ([2011] UKFTT 633 (TC)).  So as to confirm the difficulties involved, the Upper Tribunal has now reversed that decision – see Esporta Ltd v Revenue and Customs Commissioners ([2013] UKUT 173 (TCC), published 26 April 2013).

The taxpayer was a gym which charged output VAT on membership fees.  Some members had not paid the fees, so the taxpayer refused them access to the gym’s facilities until the fees were paid.  When the taxpayer eventually received these fees, it treated the payments as compensation for a breach of contract and outside the scope of VAT.

HMRC argued that output VAT should be accounted for on the recovered fees.  The taxpayer argued that no supply of gym facilities had been made; and as no supply had been made, no output VAT could be charged.

Whilst the First-tier Tribunal had agreed with the taxpayer, the Upper Tribunal agreed with HMRC’s view.  The Upper Tribunal reasoned that the taxpayer was still providing gym facilities under the terms of the membership which had not been terminated, even if the taxpayer was denying access to these facilities to those members whose membership fees were unpaid.  As such, the taxpayer was making a supply and output VAT should be charged.

Over the years there have been several cases on this point.  A common example is where one party cancels a contract and pays compensation for early termination.  However, if the contract had not been structured correctly, this can be construed as a supply by the party receiving compensation of a right to be released from the contract.  The compensation received could be subject to output VAT.

When a compensation payment is received, it is not always self-evident that a supply exists to which the compensation is linked.  Those practitioners involved with compensation scenarios should therefore ensure that VAT issues are given close attention.

For further information regarding VAT on compensation payments, please contact the TaxDesk on 0845 4900 509 and ask for Kevin Hall.