December 15, 2020

TCC rules VAT is payable on damages for compensation for breach of construction contracts

Construction Law solicitor, Lawrence Pearce, discusses a recent important verdict of the TCC in respect of the application of VAT to breach of contract compensation payments.

It has been a year dominated by the pandemic and certain other news items have become secondary. Somewhat under the radar, HMRC published its ‘Revenue and Customs Brief 12 (2020): early termination fees and compensation payments’ on 2 September and although it has been reported, we were yet to see its application in relation to construction.

The Judgment in Optimus Build Limited v (1) Matthew Southall (2) Jade McManus looks to be the first time the Courts have considered, albeit briefly, that VAT is in fact payable on damages for compensation for breach of contract.

Position on VAT until now

As his honour Judge Stephen Davies summarised at paragraph 87 of his Judgment “The conventional view has always been that VAT is not chargeable on damages for compensation for breach of contract”. This has always been the position as previous HMRC guidance said any charges/compensation following withdrawal of an agreement were not generally for a supply and were outside the scope of VAT.

HMRC has now said that following recent judgements of the Court of Justice of the European Union: 

“it is evident that these charges are normally considered as being for the supply of goods or services for which the customer has been contracted for and therefore should be subject to VAT.”

The knock-on effect is that loss of profit flowing from early termination will be liable for VAT. This is a large departure from the conventional view.  What has shocked many people within the industry is that HMRC are suggesting that past payments need to be revisited. Putting that into context, a contractor who has previously not accounted for VAT in relation to contractual termination will now be expected to account for the VAT to HMRC. This retrospective approach is likely to cause an administrative nightmare and add to cashflow issues flowing from the pandemic. We will wait to see whether HMRC apply a prospective approach going forward which would be welcome news to many.

Optimus Build Limited v (1) Matthew Southall (2) Jade McManus [2020] EWHC 3389 (TCC)

Optimus Build (OBL) were engaged to carry out building works to a residential property in Manchester. The parties were unable to agree the basis of the contract and who was responsible for the termination of the contract before the works had been completed.  OBL’s position was that the house owners had wrongfully repudiated the contract and OBL was entitled to the balance of the contract price for the works undertaken and its loss of profits on the remaining works.

Although the Judgment addresses a number of key issues in the case including contract formation, termination of the contract and the assessment of OHP, it was paragraph 87 that grabbed our attention:

“During closing submissions I asked whether the claimant was entitled to add VAT to its claim for loss of profits, as had been done in the November 2018 final account without explanation…Mr Whitfield, with impressive up-to-date knowledge, referred me to a September 2020 update from HMRC which, to summarise, indicates that its view following recent CJEU case law is that compensation payments relating to commercial payments, including early termination payments, will be subject to VAT. Given the modest amount in issue and the lack of opportunity to counsel investigate further at that stage it was sensibly agreed that I should order that any amount awarded as damages for loss of profit should be subject to VAT at the applicable rate in the event that the claimant was required to and did account to HMRC for such VAT.”

What is clear from the Judgment is that although the specific issue of VAT was not fully ‘investigated’, it reflects the brief issued by HMRC. No doubt this case will be relied upon to demonstrate that VAT is payable in relation to loss of profit claims going forward. The real issue arises for those settlements that have already taken place and no VAT was paid. This may leave a few contractors asking the question of how they are to account to HMRC retrospectively, especially after a year like 2020.

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