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Early termination penalty subject to VAT?

The Court of Justice of the EU (CJEU) in its judgement C-295/17 (MEO – Serviços de Comunicações e Multimédia SA) dealt with the question whether a fee received for early termination of a contract is subject to value added tax.

MEO provides telecommunication services in Portugal. As a part of this, the company also concludes short-term contracts stipulating that, should the customer terminate the contract before its term, the company is entitled to compensation for the loss of earnings, meaning that the customer still has to pay the contracted amount (even for the months in which the service is not provided). Therefore, the total amount paid by the customer always equals the amount for the full term, even though the services are not actually rendered until the end of such term. The company treated the amounts thus charged to customers upon early terminations as contractual penalties. As such a penalty is not subject to VAT, no VAT was paid on this amount.

CJEU previously held that if there is a direct link between the service provided and the consideration received, using the service is a customer’s right, even if it is not actually used. In the case in question, such right involves the use of telephone services. In the event of an early termination, customers choose not to use the right, despite having to pay the same price as if they had used it.

Taking the business and economic reality, the main criterion for applying the common EU system of VAT, as a basis, the early termination of a contract by a customer does not change this reality. In fact, the company maintains the same level of revenue as if the services had not been discontinued. CJEU thus concluded that such a pre-set amount paid by the customer shall be treated as a consideration for rendering services, and as such be subject to VAT.

The fact that the contractual purpose of the amount invoiced is to deter customer from disregarding the tie-in period or that it is regarded as a contractual penalty under national law does not affect this conclusion. In both situations, the company received identical income, the CJEU confirmed.

In the light of this judgement, companies rendering services for which they charge their customers a pre-set amount in advance should review the VAT treatment of these transactions.