In principle ‘compensation' is outside the scope of VAT if it is not considered compensation in return for the supply of goods or services.
Often a severance payment with respect to a service contract with an agreed minimum duration is actually qualified as such. However, VAT rules do not follow this qualification in civil law to the letter. To avoid a later dispute it is advisable to stipulate the appropriate VAT administration method in the agreement.
Service contracts with an agreed minimum duration include, for example, the rental or leasing of movable property, subscriptions, etc.
Under such an agreement, the customer undertakes to pay periodic compensation for services rendered during the agreed period. Moreover, the customer will have to make a severance payment if the agreement is terminated as a result of their actions or an error on their part before the specified minimum period has elapsed.
However, with an agreement of this nature the customer also has a right not to make use of the services, providing they pay the agreed compensation in full. If they opt to do so, this shall not affect the administration of VAT. Such was the verdict of the Court of Justice, which decided, for example, that the administration of VAT for an airline ticket cannot be changed if the customer does not show up for the flight.
VAT administration in line with the verdict of the Court of Justice
The Court of Justice extends the above reasoning to severance payments for service agreements with an agreed minimum duration.
In a first case (C-295/17), the Court ruled that a severance payment was subject to VAT if the amount was equal to the compensation the customer would have to pay for the normal implementation of the contract.
In some subsequent judgments (C-242/18 and C-43/19), the Court ruled that a severance payment was also subject to VAT if, in the event of termination by the customer, the service provider was only entitled to a share of the costs incurred. An additional condition is that the agreement must stipulate clearly defined criteria to determine the amount of the severance payment. After all, in such cases the service provider takes into account the agreed minimum duration and the possible severance payment when pricing periodic compensation fees.
The fact that the termination results in no further services being provided by the service provider before the end of the agreed minimum contract period has no further effect on the VAT administration of the severance payment.
Have your severance clause checked
Price agreements in a contract with an agreed maximum duration usually specifically state whether prices include or exclude VAT. A severance clause usually does not mention this, because the parties consider a severance payment as 'compensation' not subject to VAT.
Do you conclude contracts with an agreed minimum duration? If so, it is advisable to have the wording of the severance clauses checked. The way in which the severance payment is defined can be decisive when determining whether or not it is subject to VAT.
In the light of the above case law, it is advisable to state specifically in the agreement that the agreed severance payment is inclusive or exclusive of VAT. This will avoid unpleasant disputes about it at a time when the relationship may already have become acrimonious.
If you are concluding agreements of this kind within an international context, this need for clarification is even more important. In many countries, the VAT authorities have not yet clarified how this jurisprudence affects their position. The British VAT authorities did adapt their guidance in September 2020. It now considers compensation for the early termination of a contract to be compensation for the supply of goods or services subject to VAT. Even if it is referred to as 'compensation' in the agreement.
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If you have further questions about this topic or would like advice on how best to adapt your agreements, our experts are here to help so please do not hesitate to contact us.