Commercial penalties may be subject to VAT

Commercial penalties may be subject to VAT

Companies renting properties or service providers on a subscription basis such as telecoms (telephony, internet, television), public utilities, electronic publications and others are affected by a recent decision by the Court of Justice of the European Union.

The amounts collected by these companies for the termination of contracts by the clients or for reasons attributable to them, before the expiration of the minimum contract period, will be subject to VAT.

In most cases, for the repair of the damage caused and the discouragement of non-observance of the contractual commitments between the parties, the suppliers provide in the contract amounts due for termination or early termination for reasons imputable to the clients.

In most cases, amounts for denunciation / termination are billed as contractual penalties, outside the scope of VAT (excluding VAT).

However, the Court of Justice of the European Union recently issued a judgment in Case C-295/17 MEO - Serviços de Comunicações e Multimédia SA.

According to this, the collection of such amounts represents remuneration for the provision of services falling within the scope of VAT (subject to VAT).

In practice, if such amounts correspond to those which the provider would have received until the end of the contractual period had there not been an early termination by the customer or for reasons attributable to the customer, they should be invoiced with VAT because they pay the services originally contracted.

In real estate, penalties / Penalty Clause are a common feature in rental contracts. From now on, the way this clause is formulated can lead to a differentiated VAT treatment: whether or not VAT is applied to those amounts.

Therefore, in rental contracts, the Penalty Clause should regulate as fully as possible the nature of the lessee's financial obligations and the terms and conditions of payment: between the time of the contract being denounced and that of the surrender of the space to the landlord, and after taking over by the landlord, accurately reflect the economic substance of the commercial operation.

Applying VAT to the amount of commercially agreed penalty for early termination / termination of rental contracts may lead to unrealistic expectations from the owner and / or additional financial exposure to the tenant.

We also recall that the Romanian legislation expressly provides for the possibility for the parties to contract by contract a benefit in exchange for the right of early termination.

As regards the VAT related to these amounts, it will be deducted by the beneficiaries registered for VAT purposes with full right of deduction.

A problem will arise in the case of companies that do not have full VAT deduction, such as those in the banking, insurance, leasing or medical sectors, for which this tax is an irrecoverable cost if utilities are allocated to exempt operations.

In addition, we note that a major impact of this decision of the Court of Justice of the European Union will be felt among legal entities not registered for VAT purposes but also among individuals who will bear the cost of VAT on pre-termination amounts of contracts . The clearest example is telecom service contracts (internet, telephony, cable TV).

Last but not least, we also recall the need for companies affected by this decision to carry out a historical analysis of the VAT treatment applied to the amounts already received for the early termination of contracts until the Court of Justice of the European Union issues it. As a result of the decision, additional VAT charges may be triggered on these historical amounts.

Therefore, in the event of early termination of the contract at the initiative or the fault of the consumer, the latter will have to bear the payment of contractual penalties which are usually equal to the value of the subscription until the end of the contract, as well as the related VAT.