Since 1 April 2022, HMRC treats most early termination fees as further payment for the supply the customer signed up to, so they carry VAT at the same rate as that supply, even if the contract calls them compensation or damages. Payments stay outside the scope of VAT only where nothing is supplied in return, such as genuine damages for loss or harm, punitive penalties designed to deter a breach, and compensation paid by a supplier who has failed to perform.

What changed, and when?

For many years HMRC’s guidance said that charges for withdrawing from an agreement were generally not payment for a supply and were outside the scope of VAT. Two judgments of the Court of Justice of the European Union, MEO (C-295/17) and Vodafone Portugal (C-43/19), led HMRC to change its view. It first did so in Revenue and Customs Brief 12 (2020), which was suspended in January 2021 after industry representations.

Revenue and Customs Brief 2 (2022) replaced it with a revised policy taking effect from 1 April 2022. HMRC said the revised policy would bring fewer payments into VAT than the 2020 version. All businesses had to adopt it by 1 April 2022, including any business holding a specific HMRC ruling that such fees were outside the scope. The detailed guidance is now in the VAT Supply and Consideration manual at VATSC05910, VATSC05920 and VATSC05930.

Why is an early termination fee treated as payment for a supply?

A payment is consideration for a supply if there is a direct link between what the supplier does and what the customer pays, with reciprocal obligations between them. The CJEU’s reasoning, which HMRC quotes in VATSC05910, is that a customer who signs a contract with a minimum term pays for the right to the supplier’s performance, whether or not they use it. The supplier has made the service available. A fee charged when the customer ends the contract early is part of the price the customer committed to, not a separate payment for a loss.

VATSC05920 sets out HMRC’s policy: payments arising from early termination are further consideration for the contracted supply where they are linked to it, which will normally be the case. This applies whether the original contract provided for termination or a separate agreement is reached later. The fee does not have to equal the remaining payments. Vodafone Portugal applied the same reasoning where the amount was lower than the customer would have paid had the contract run its course.

HMRC’s own examples in Brief 2 (2022) are a fee for leaving a mobile phone contract early and a fee for ending a car hire contract early. Both are liable to VAT if the underlying supply is.

Does the label “damages” or “compensation” change anything?

No. VATSC05910 says the description of a fee does not affect whether there is a supply. VATSC05930 deals with liquidated damages clauses, which commonly set a formula for compensation on early termination. Because these payments arise from events the contract provides for, they are part of the agreement. If they cover the supplier’s costs of making the supply available, or equate to what would have been charged had the contract run as expected, they are further consideration.

HMRC specifically says vehicle finance leases that allow the customer to cancel after an initial period on payment of a termination fee covering future rents fall into this category. Its previous guidance treated those fees as outside the scope, but it now says the CJEU judgments make clear they are taxable.

When is a payment outside the scope of VAT?

The link to the supply has to be real. HMRC’s guidance identifies several situations where it is missing.

  • Punitive charges. VATSC05930 says that if a fee is clearly punitive and designed to prevent a breach rather than compensate for lost income, it is outside the scope. VATSC06140 applies the same idea to parking: excess charges for breaching parking terms, such as overstaying or parking outside a bay, are outside the scope, while a published extra charge for staying longer is further payment for parking.
  • Damage beyond what was agreed. VATSC05910 gives the example of a hired car written off by the customer. A fee for that is not further payment for the hire, because the supplier never agreed that the customer could write the car off.
  • Dilapidations. HMRC’s policy is not to treat dilapidation payments at the end of a lease as further consideration for the lease, unless there is evidence of value being shifted from rent to avoid VAT.
  • Damages for a wrong. VATSC06820 says a payment to settle a claim for libel, slander or unauthorised use of a trading name is not generally consideration. It becomes taxable if the settlement grants a right, such as permission to keep using the name, as in Cooper Chasney Ltd. Settling out of court does not of itself create a supply.
  • Compensation for lost or destroyed goods. VATSC06190 treats payments for goods lost or destroyed while hired out or left for repair as outside the scope.
  • Interest for late payment. VATSC06810 says interest awarded or agreed for delay is outside the scope, even when the underlying debt is taxable.

What if it is the supplier who breaks the contract?

VATSC05930 distinguishes two outcomes. If the supplier reduces its price because what it delivered fell short, the consideration is lower and so is the VAT; a reduction made after the period of the original supply is adjusted by both supplier and customer under regulation 38 of the VAT Regulations 1995, as explained in VAT on credit notes and discounts. If the price stands but the supplier pays the customer liquidated damages for actual loss suffered, for example knock on costs to the customer’s business, that payment is outside the scope and does not reduce the original VAT.

How does this differ from deposits and dispute settlements?

A deposit or advance payment for a supply is already part payment, so VAT is due on it when received and is not reversed if the customer walks away and the deposit is kept. VAT Notice 700 paragraph 8.13 confirms that a retained payment for a supply the customer fails to take up cannot be reclassified as outside the scope. See VAT on deposits and advance payments.

Where a customer disputes a bill and later pays in settlement, VATSC06810 treats the amount paid in satisfaction of the supplier’s claim as consideration for the supply, liable to VAT if the supply was taxable. An ex gratia payment is outside the scope only if it is clearly additional to the price, not obligatory, and the supply would happen anyway (VATSC06170). In Edenroc Limited an arbitrated extra sum on a refurbishment contract was held to be further consideration.

What does an early exit look like in numbers?

Illustration only. A business rents a photocopier for 36 months at £100 a month plus VAT at the standard rate. After 24 months the customer ends the contract and, under the terms, pays a termination fee of £900, representing 75% of the 12 remaining monthly charges. The fee is further consideration for the rental, which is standard rated, so the supplier treats £900 as VAT inclusive and accounts for £150 of output tax (one sixth), unless the contract makes clear the £900 is VAT exclusive, in which case £180 is added. If the copier had instead been badly damaged by misuse and the customer paid for repairs, that payment would be outside the scope.

What mistakes come up most often?

  • Relying on old HMRC guidance or a pre 2022 ruling that early termination fees are outside the scope. Brief 2 (2022) overrides those.
  • Assuming the word “compensation” in the contract decides the VAT treatment.
  • Applying VAT at the wrong rate. The fee follows the liability of the underlying supply, so a fee for leaving an exempt contract is exempt. Where a contract covers several supplies, VATSC05920 says to apportion on a reasonable basis.
  • Charging VAT on genuinely punitive charges or on compensation for damage outside the agreed use.
  • Failing to correct past errors. Brief 2 (2022) says businesses that followed the 2020 guidance and accounted for VAT on fees now outside the scope can correct this in the normal way, covered in correcting VAT errors.

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Sources

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.