26 December 2018
An ‘indemnity’ falls outside the scope of VAT if the amount does not qualify as the consideration for the supply of a service or a good. In some situations it can be hard to assess whether or not this is the case. This can in particular give rise to discussion in the context of contractual indemnities.
The European Court of Justice (ECJ) has recently given a ruling on the VAT qualification of an amount due by a customer due to the early termination of a service contract (C-295/17). The contract provided in a minimum duration and a lump sum indemnity in case of early termination by the client. The amount of the indemnity corresponded to the remaining payments the client had to make until the end of the minimum duration. The ECJ ruled in this case that the amount due by the client did not qualify as an indemnity for VAT purposes, but as a VAT taxable consideration for a service.
According to this case, the VAT qualification of the amount due by the client depends on the fact whether the termination of the service agreement has changed anything to the economic reality between the supplier and the customer. In practice, it will be rather exceptional that the termination of a contract does not change the economic reality between the supplier and the customer, but this can occur in situations where the contract does not include any obligation for the customer to use the service.
If the client has a free choice to not use the service and the amount he pays for the service is not influenced by the fact whether or not he uses the service, according to the ECJ, the VAT treatment cannot be influenced by the decision of the client to not use the service. The ECJ had already ruled previously that the VAT treatment of a travel ticket does not change if the client does not show up for his flight.
The ECJ has now ruled that the same reasoning should be applied to a service contract (such as a telecom subscription) with a minimum duration, which does not include an obligation for the client to use the service, and which provides that in case of early termination the client needs to pay a lump-sum amount equal to the remaining payments which were normally due until the end of the minimum duration. In such case, the early termination of the contract does not change the economic reality between the supplier and the customer.
The VAT treatment of a contractual indemnity in case of the early termination of a contract should be assessed on a case by case basis. If the termination does not change anything to the economic reality between the supplier and the customer, the amount due will not qualify as an indemnity for VAT purposes, regardless of the civil law qualification of the amount.