From the delayed Euro 2020 football tournament to canceled or renegotiated mergers and acquisitions (M&A) transactions: in less than four months the Covid-19 pandemic has totally disrupted businesses and all the plans they had made for 2020. Many contracts have been amended or canceled. When these actions involve payments, value-added tax (VAT) can arise.
Now countries are easing lockdown restrictions, businesses are getting some breathing space. With the peak of an intense period behind them, businesses—eager to recapture a sense of normalcy—are now working on plans to return to the relatable version of the past (“the new normal”) and they may find the time to reflect on the past couple of months.
During the outbreak, businesses have been prompted to act fast. Heat-of-the-moment decisions have been made without much time to think these through. The impact of these decisions from the perspective of VAT, not often a driver in business decisions or a showstopper, may not have had all the attention it needed.
Contracts that have been amended or canceled may not attract VAT, but this is not always the case. With the standard rates in the EU varying from 17% to 27% a misinterpretation can turn out to be costly especially if the counter-party—be it a shareholder, an exempt business, a private individual—is not (fully) entitled to VAT recovery.
Business that have faced changes or cancellations due to the crisis are recommended to validate the VAT treatment applied to payments in respect of these actions. But when do such payments attract VAT and when not? As we will see, the (legal) basis on which such payments are made will be key when determining the VAT liability.
When Amendments and Cancellations Attract VAT
If a contract gives the right to change or cancel in exchange for payment, the payment is subject to VAT if it can be seen as a remuneration paid for a service. This will be the case if:
- one of the contracting parties intends to change or cancel the contract;
- the counter-party agrees on the change or cancellation;
- the counter-party demands and receives a payment in return; and
- there is a direct connection between this payment and the agreement on the change or cancellation.
The right to change or cancel a contract could exist under the original contract. It could also be that the original contract does not include that specific right and that a standalone contract (“termination agreement”) is concluded.
Indicators that Amendments and Cancellations do not Attract VAT
The application of the listed criteria is more complex than one would expect. There have been various cases where the European Court of Justice ruled on the VAT treatment of payments in exchange for amendments and cancellations. The judgments in these cases (that mostly related to businesses in the hospitality and travel sector) are providing some guidance, but the VAT status of payments in respect of a change or cancellation remains fact sensitive and subject to interpretation. There are, however, a few indicators that such payments should be seen as compensation payments that are out of scope of VAT. This may be especially the case if:
- the level of payment in respect of the amendment or cancellation is only a proportion of the fees agreed for the original supply of goods and or service; and
- the agreed supply of goods and or services has not been and will not be (fully) made.
What Should Businesses do when Confronted with Changes and Cancellations?
Businesses operating in the hospitality and travel sector, the type of businesses that are to a certain extent used to (a daily practice of) changes and cancellations, may through the years have found their way to manage payments in respect of changes and cancellations from an EU VAT perspective. Now the economy has been brought to a near standstill, business from many other sectors have also been facing numerous changes and cancellations.
In particular for those businesses that are less used to a practice involving frequent changes and cancellations, it is recommended that they take the following steps:
- take inventory of contracts that have been altered or terminated;
- carefully review the set or accepted terms governing the contracts of these transactions;
- reflect on options to optimize, especially if the counter-party that is not (fully) entitled to VAT recovery;
- consider their position towards their counter-party; and
- consider seeking confirmation from the local tax authorities on the VAT treatment.
Break Fees in Deal Making
Apart from its impact on businesses carrying out their daily economic activities, the Covid-19 pandemic has also put a huge strain on deal making. The crisis has contributed to a substantial drop in the market value of many businesses, and it is hard to predict when a recovery may occur. Views on what is a fair consideration for the value exchanged will have developed. Also, parties may have taken the decision to withdraw from deals with substantially increased risk profiles. As a consequence, many deals over the past couple of months have been renegotiated or canceled.
As parties may incur significant costs in the bidding process, it is common to agree a break fee arrangement should the deal fail. Here VAT can also arise and, depending on the numbers, the financial impact can be significant. If the break fees attract VAT, which is likely if it is in fact a consideration for a supply of services such as engaging in discussions in relation to a potential takeover, the question around the recoverability inevitably follows.
Parties that are in the process of renegotiating or canceling a deal, especially if this is as a consequence of the Covid-19 pandemic, are recommended to take steps to:
- understand the fee arrangements;
- review the recovery position of the party that has the obligation to pay the break fee as well as the recovery position of the party receiving the break fee; and
- take (early) professional advice.
Jan Sanders is a VAT Partner and Sofie Rijnvos is a VAT adviser at PKF Netherlands.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.