VAT on early termination compensation in telecommunications contracts: a critical M&A consideration

M&A in the telecommunications sector involves multifaceted risks, including tax liabilities that can significantly impact the transaction's overall value and success. One of the crucial tax considerations in acquiring a telecommunications operator is the treatment of VAT on compensation received for early contract termination during a loyalty period. This article examines the VAT implications of such compensation and the impact on M&A transactions in the telecommunications industry.

Council Directive 2006/112/EC (the VAT Directive) establishes the common system of VAT within the EU. According to Article 2(1)(c) of the VAT Directive, the supply of services for consideration within a member state by a taxable person is subject to VAT. The key determinant is whether the transaction involves a supply of services to which the consideration received is directly linked.

The VAT Directive also stipulates that compensations and penalties are not part of the tax base of a supply; i.e., they are not subject to VAT.

Taking Portugal as an example of the approach in some countries, the VAT Directive is implemented through the VAT Code, with specific provisions regulating the telecommunications sector outlined in the Electronic Communications Law. These laws stipulate the conditions under which telecommunications operators can charge fees for early contract termination, and the associated VAT implications. In fact, the legislation in Portugal attempted to forbid stipulations for compensation in cases of early termination of telecommunication contracts.

In other countries, compensation for early termination is generally allowed and is per se outside the scope of VAT.

Advocate General Kokott's opinion in case C-295/17 focused on distinguishing between taxable services and non-taxable compensation for pecuniary damage. Payments for early termination were considered under VAT law to determine if they constituted consideration for a service or compensation for non-performance.

The Court of Justice of the European Union ruled in cases C-43/19 and C-295/17 that amounts received by a telecommunications operator for early contract termination during a loyalty period are subject to VAT. The payments were viewed as remuneration for services, forming part of a contractual relationship characterised by reciprocal performance. It should be noted that the VAT charge should be limited only to the actual amounts paid by the customer after the termination of the contract and during the loyalty period.

When acquiring a telecommunications operator, understanding the VAT treatment of early termination compensation is vital for several reasons:

• Tax liability transfer – the acquiring entity may inherit significant tax liabilities if the target company has not adequately accounted for VAT on early termination compensations. This can lead to substantial unexpected financial obligations post acquisition.

• Valuation impact – the potential tax liabilities can affect the valuation of the target company. Proper due diligence must include an assessment of the VAT treatment of early termination fees to avoid overvaluation.

• Contractual obligations – acquirers must review the contractual terms of the target company's customer agreements to understand the conditions and potential VAT implications of early terminations. This ensures that future financial forecasts and valuations are accurate.

• Compliance risks – ensuring compliance with the applicable VAT regulations is critical to avoid penalties and interest. The acquiring company must assess the target's historical compliance and rectify any discrepancies to mitigate future risks.

During the due diligence phase of an M&A transaction in the telecommunications sector, the following steps are crucial:

• Review contract terms – analyse the target company's customer contracts to identify terms related to loyalty periods and early termination penalties;

• Assess historical VAT treatment – examine how the target company has historically treated VAT on early termination compensations and check for any disputes or ongoing litigation with tax authorities;

• Evaluate potential liabilities – quantify potential VAT liabilities arising from early termination compensations to accurately reflect these in the transaction's financial model; and

• Consult legal and tax experts – engage legal and tax professionals with expertise in telecommunications and VAT law to ensure comprehensive risk assessment and mitigation strategies.

The VAT treatment of early termination compensation in telecommunications contracts is a significant tax risk in M&A transactions. Acquiring entities must conduct thorough due diligence to understand the VAT implications, evaluate potential liabilities, and ensure compliance with legal and regulatory frameworks. Properly addressing these issues can safeguard against financial surprises and contribute to a successful and smooth acquisition process.