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The title uses “GST”, but the evidence and rules explained here are for UK VAT. GST systems in other countries use different legislation and tests; do not apply this article to another jurisdiction without checking its tax authority’s current guidance.
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The UK VAT test: what is the payment really buying?
HM Revenue & Customs (HMRC) starts with the underlying bargain, not the label on a bank transfer or settlement agreement. Consideration exists when one party gives something in return for a supply and there is a direct link between the payment and that supply. The supply may be goods, services, a right, the surrender of a right, or another legally enforceable benefit.
The agreement can be written or oral. Consideration can be money or something non-monetary. Calling an amount “damages”, “compensation”, “liquidated damages”, “penalty”, “ex gratia” or “settlement” does not determine its VAT treatment.
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Use these questions before deciding whether VAT belongs on the amount:
- What was supplied? Identify the goods, services, access, licence, release, consent or other right that one party provided or promised.
- Who pays and what does the payer receive? Look for the reciprocal benefit, including a right to continue, stop, use, surrender or settle something.
- Is there a direct link? Ask whether the payment is the price, part of the price or a contractual amount connected with the supply.
- What does the settlement resolve? It may settle an unpaid price for an existing supply, compensate an independent loss, purchase a new right, or activate a term in the original contract.
- Are components separable? Principal, interest and amounts for different rights should be analysed separately where the agreement and evidence support that division.
- What is the underlying VAT liability? If the payment is consideration, it follows the VAT treatment of the supply. Consideration does not automatically mean standard-rated VAT.
These questions reflect HMRC’s VAT Supply and Consideration manuals, including VATSC05910, VATSC06810, VATSC06820, VATSC05920, VATSC05930, VATSC06170 and VATSC06190. The pages were published on 10 April 2016 and are shown as updated on 7 March 2025. HMRC’s VAT Notice 700 was shown as last updated on 25 June 2026; check the live guidance before filing a return because tax rules and administrative guidance can change.
Quick comparison of common settlement payments
| Payment pattern | What the payer receives | Direct link to a supply? | Usual UK VAT result |
|---|---|---|---|
| Disputed price for goods or services already supplied | The goods or services that were supplied, even though the price is disputed | Yes; the settlement resolves the price of that supply | Consideration for the original supply; apply that supply’s VAT liability |
| Damages for a wrong, with no reciprocal supply | No goods, service or right from the claimant; payment compensates a loss | Generally no | Normally outside the scope of VAT |
| Payment for granting, surrendering or releasing a right | A licence, consent, release, name or other enforceable right | Yes | Consideration for that supply; apply its VAT liability |
| Contract-linked early termination or liquidated damages | Release from the contract or the contractual benefit of ending it | Often yes, where linked to the original supply | Usually further consideration for the contracted supply; follow its VAT liability |
| Separately agreed late-payment interest | Compensation for delay in paying, rather than the underlying goods or services | Not for the interest component in HMRC’s disputed-supply guidance | Outside the scope for that interest component; analyse the principal separately |
When a disputed invoice is settled
Suppose a supplier has delivered goods or completed work, but the customer disputes the invoice because of price, quantity or workmanship. The parties later agree that the customer will pay a reduced amount in full and final settlement. HMRC treats the agreed amount as consideration for the supply already made.
The dispute does not turn the original price into damages. The customer is paying to resolve its obligation for the goods or services received. The same result applies whether the settlement follows a court judgment or an out-of-court agreement.
If the underlying supply was taxable, the settled amount is taxable according to that supply’s rate. If the supply was zero-rated, reduced-rated or exempt under the applicable rules, the settlement does not become standard-rated merely because it is called a settlement.
Interest for late payment is a distinct component in HMRC’s example. Where the agreement separately identifies interest awarded or agreed for delay, HMRC treats that interest as outside the scope of VAT, while the principal amount remains consideration for the supply. Keep the calculation and wording clear enough to show which amount is principal and which is interest.
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Damages where the claimant supplies nothing in return
A payment to settle a claim for libel, slander, unauthorised use of a trading title or a similar wrong is generally not consideration. The claimant is compensated for an injury or loss and does not provide goods, services or a right in exchange for the money. HMRC states that there is no supply merely because the parties agree to settle out of court.
This conclusion is fact-sensitive. If the claimant gives the payer a new benefit as part of the settlement, that benefit can be a supply. For example, permission for future use of a trading title, name or logo is a right granted in return for payment. HMRC’s manual discusses Cooper Chasney Ltd, where a £30,000 settlement was treated as consideration for surrendering rights to a name and logo. The amount is a case example, not a statistic or a general threshold.
Read the operative clauses, not just the recital describing the payment as compensation. A release of past claims may be part of settling litigation, while a licence, consent or promise not to enforce a right in defined circumstances may be a separately identifiable benefit. The legal effect and commercial substance determine the VAT analysis.
Early-termination fees: why “penalty” is not enough
HMRC generally treats an early-termination payment as further consideration for the contracted supply when it is linked to that supply, which HMRC says will normally be the case. This applies whether the original contract contains a termination fee or the parties later agree an amount to end the contract.
The question is whether the customer is paying for the supplier’s contractual performance or for the agreed ability to end the arrangement. A fee can compensate the supplier for making capacity, access or services available during a minimum term. If the payment is economically part of the price for that commitment, it follows the VAT liability of the original supply.
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HMRC discusses the Court of Appeal decision in Esporta Ltd v Revenue and Customs [2014] EWCA Civ 155. The manual reproduces this sentence from paragraph 31:
“I cannot see how, as a matter of principle, and looking at the contract at the time it was made, the default provisions in the contract should affect the underlying analysis of the services that are to be provided in consideration for the fees.”
The point is not that every termination amount is taxable or that every default clause is irrelevant. It is that the original contractual bargain must be examined. A payment labelled a penalty can still be consideration if it is connected with the supply and forms part of what the customer agreed to pay.
Liquidated damages and the original bargain
Liquidated damages are pre-agreed amounts intended to address a specified contractual event. The label alone does not decide whether VAT is due. HMRC says to examine whether the payment is part of the contractual arrangement, whether it covers costs of making the supply available, and whether it broadly equals what would have been charged had the contract run as expected.
HMRC’s discussion refers to the CJEU’s Vodafone Portugal, C-43/19, in the context of early termination. The sentence reproduced in the manual states:
“In the context of an economic approach, an operator determines the price for its service and monthly instalments, having regard to the costs of that service and the minimum contractual commitment period… …the amount payable in the event of early termination must be considered an integral part of the price which the customer committed to paying for the provider to fulfil its contractual obligations.”
That quotation concerns the facts and reasoning of the cited case. It supports looking at the economic and contractual connection to the original supply; it is not a universal rule that every liquidated-damages payment is consideration or that every such payment is outside the scope of VAT.
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Voluntary goodwill and ex gratia payments
An ex gratia or goodwill payment can be outside the scope of VAT when it is genuinely voluntary. HMRC identifies three conditions:
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- there is no obligation to pay it; and
- the supply will still be made if the amount is not paid.
If an agreement makes the amount an additional charge for the supply, it is further consideration and follows the supply’s VAT liability. The wording “ex gratia” cannot override a contractual obligation or the commercial reality.
HMRC’s VATSC06170 manual describes a tribunal case in which an amount called ex gratia was still treated as further consideration for refurbishment work. When reviewing a goodwill payment, compare the customer’s position with and without payment. If payment is necessary to obtain, preserve or complete the supply, the direct link is stronger.
Compensation for lost or damaged goods
HMRC gives an example in which goods are lost or destroyed outside the owner’s custody and a payment covers repair or replacement. Because no supply is made for that payment, HMRC treats it as outside the scope of VAT.
This is a specific example, not a blanket rule for every amount called compensation. If the payment also buys a service, a replacement right, a licence, a release or another benefit, that separate element must be analysed. Separate the loss payment from any amount that pays for a new supply.
What to do after deciding that a payment is consideration
Classification is only the first stage. Once a payment is consideration, apply the VAT rules for the underlying supply.
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Apply the supply’s VAT liability
Determine whether the supply is standard-rated, reduced-rated, zero-rated or exempt under the rules that apply to that supply, customer and place of supply. A consideration finding does not itself select a rate. For example, a settlement of a price for a qualifying zero-rated supply follows the zero-rating rules; a settlement for an exempt supply does not become taxable solely because litigation occurred.
Value monetary consideration correctly
Where consideration is wholly money, the amount paid is treated as VAT-inclusive unless the agreement and invoicing establish the taxable amount and VAT separately in accordance with the rules. Do not add VAT mechanically to a figure that already represents the total agreed payment.
Value non-monetary consideration
Consideration can be non-monetary, such as a transfer of property, services in exchange, or another right. HMRC Notice 700 explains that the value is generally the monetary equivalent or open-market value of what is given in exchange. Record how that value was determined and apply the VAT liability of the supply received.
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Keep separately identifiable late-payment interest apart from the settled principal where the facts support it. HMRC’s disputed-supply guidance treats the interest component as outside the scope of VAT because it compensates for delay. The principal remains subject to the VAT treatment of the original supply. Do not describe the entire settlement as “interest” when only a calculated portion relates to delay.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.A practical review procedure for a settlement agreement
- Collect the original documents. Assemble the contract, order, invoice, credit notes, delivery or completion evidence, correspondence, pleadings and draft settlement.
- Map each obligation. List what the supplier delivered, what the customer was required to pay, and any right or release created by the settlement.
- Split the consideration. Identify principal for goods or services, interest, damages, legal costs and payments for licences, releases or future permissions.
- Test reciprocity. For each component, state in one sentence what the payer receives in return. If there is no identifiable benefit, explain why the amount is compensatory rather than consideration.
- Check the direct link. Decide whether the amount settles an existing price, forms part of the original contractual price, buys a new right, or compensates an independent loss.
- Determine the underlying VAT liability. Apply the rate and place-of-supply rules for the relevant goods, services or rights.
- Confirm the value and VAT wording. Establish whether figures are VAT-inclusive or exclusive and ensure the settlement, invoice or credit note reflects the agreed treatment.
- Record the reasoning. Keep the agreement, calculations and written analysis with VAT records so the treatment can be explained to HMRC if questioned.
- Reflect the result in the VAT return. Include consideration in the appropriate boxes and period, or retain evidence for an outside-scope component that is not reported as taxable turnover.
Common mistakes and how to avoid them
- Relying on the label. Replace “compensation” or “penalty” with a description of the actual bargain and benefit.
- Assuming an out-of-court settlement is outside scope. A settlement of an unpaid supply price remains consideration even without a judgment.
- Treating every damages payment as taxable. A genuine payment for loss with no reciprocal supply is generally outside scope.
- Ignoring rights. A release, licence, consent or permission can itself be a supply.
- Putting the whole amount in one category. Separate principal, interest and distinct rights when the facts support separate treatment.
- Adding VAT without checking whether the amount includes it. Confirm the agreed consideration and invoice wording before calculating output tax.
- Assuming consideration means standard rate. Apply the rate, exemption or zero-rating that belongs to the underlying supply.
- Using a generic answer for another country. UK VAT analysis cannot be transplanted to a GST jurisdiction without checking that country’s legislation and guidance.
Records, software and professional responsibility
Keep the contract, settlement terms, invoices, calculations, correspondence and explanation of the VAT decision together. HMRC Notice 700 states that VAT businesses must use Making Tax Digital-compatible software for applicable VAT obligations. Software can help preserve records and submit returns, but it cannot decide whether a payment is consideration; that classification still depends on the facts and agreement.
HMRC also states that there is no requirement to employ an accountant. The taxable person remains responsible for the accuracy of its VAT affairs. A large, unusual or multi-part settlement may justify obtaining UK VAT advice before signing, particularly where rights are granted, a contract is terminated early or the payment mixes principal, interest and damages.
How the UK answer differs from the word “GST”
“GST” is used in many jurisdictions, each with its own definition of a taxable supply, compensation, damages, financial charges and settlement adjustments. Some systems may use different rules for out-of-court settlements, termination fees or interest. The analysis in this article is limited to UK VAT and HMRC guidance. For a non-UK transaction, identify the country, the relevant tax authority and the place-of-supply rules before deciding whether tax should be charged.
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Key takeaways
- Start with the supply and reciprocal bargain, not the payment’s description.
- A settled claim for a price already due for goods or services normally remains consideration for that supply.
- Damages are generally outside the scope when the claimant supplies nothing in return, but granting or surrendering a right can create a taxable supply.
- Early-termination and liquidated-damages payments require close examination and are often further consideration for a contract-linked supply.
- Separately identified late-payment interest is treated as outside the scope in HMRC’s disputed-supply guidance, while the principal follows the original supply.
- Once consideration is established, apply the underlying supply’s VAT liability and the correct valuation rules.
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