Is compensation for damage taxable for VAT?
The line between a payment for loss suffered and consideration for a supply is a fine one. We work through the distinction using a lease termination payment.
The line between a payment for loss suffered, which is outside the scope of VAT, and consideration for a supply made for consideration, which is within it, is a fine one. We discuss the topic using a case study and the Court of Justice's judgment in Lubbock Fine & Co of 15 December 1993 (C-63/92).
The situation
Orion BV lets office space to WS BV. The parties are not connected and do not form a VAT group. The letting is exempt from VAT and the lease runs until 1 April 2024.
The parties entered into discussions about ending the lease early because of a planned redevelopment of the site. They reached agreement and concluded a termination agreement providing that the lease will end by 15 July 2022 at the latest. By signing, WS BV agrees to termination before that date or as much earlier as possible, and receives a termination payment of € 225,000 from Orion BV.
The question
Does WS BV owe VAT on that payment?
Working it through
Compensation for damage is in principle outside the scope of VAT, because it is not paid in return for an agreed supply. Its defining feature is that someone suffers loss against their will and is compensated for it.
It would be too blunt, however, to say that VAT is never due on compensation. Sometimes a payment is agreed for loss that will be suffered, and such a payment counts as consideration for a taxable supply. For every payment of this kind that a business receives, it is therefore necessary to establish whether it is consideration for a supply.
Compensation is within the scope of VAT where someone agrees to something and receives a payment for it. Where parties agree a termination payment when one of them ends a contract, that payment is in our view taxable. It is paid for the other party's service: voluntarily cooperating in the termination, in other words voluntarily giving up the right to require performance. That is in line with Lubbock Fine & Co.
In this case Orion BV pays for WS BV's service, namely voluntarily cooperating in the termination. WS BV agrees to something and receives payment for it, so the termination payment is within the scope of VAT.
Within the scope does not mean taxed, however. It is not taxed where an exemption applies. In Lubbock Fine & Co the Court held that voluntarily cooperating in a termination, that is giving up the right to require performance of a lease, receives the same VAT treatment as the original letting. The termination payment therefore follows the treatment of the original lease. Because Orion BV lets the property exempt, WS BV owes no VAT on the payment.
Why this matters in practice
Calling a payment compensation does not mean no VAT is due: the label the parties choose is not decisive. In some circumstances compensation counts as consideration for a supply. If you are unsure whether VAT is due, have it assessed.