VAT Alert: Compensation-Type Payments

The Federal Tax Authority (FTA) recently issued a public clarification on the treatment of Value Added Tax (VAT) on compensation payments. The issue discussed in the clarification relates to whether VAT is due on payments made by one business to compensate another business for any loss, omission or wrongdoings.

The UAE VAT laws provide that in cases wherein payment is not made as consideration for a supply of goods or services, the obligation to pay VAT on such supply does not arise.

With the help of this clarification, the FTA has laid down the following principles that should be used to determine if VAT should be due on compensation payments:

• A contractual payment to compensate for loss
• A payment to settle a dispute
• A fine or penalty
• Payment for damaged goods

A Contractual Payment to Compensate for Loss

The best example for such a case is liquidated damages. Liquidated damages are the amounts agreed between the parties at the time of signing the contract in case any party breaches the contract. The rationale to pay the amount is not in relation to any supply of goods or services but to make good the loss suffered by one party due to commission/ omission of an act by other party. Thus, such payments are outside the scope of VAT.

Examples are – Early termination of contract or late performance of service.

It is pertinent to note that such payments do not include the cancellation charges charged by the hotel for cancellation of a booking irrespective of the room being available to the guest or not since the charges are taken for cessation of a right, which is a supply of service by the hotel and thus, chargeable to VAT.

A Payment to Settle a Dispute

The clarification provides that in cases wherein a dispute is settled and payment is awarded to a party, it is imperative to consider the reason behind the payment to determine treatment of VAT. Following are some of the cases wherein VAT treatment has been identified:

A Fine or Penalty

Fines and penalties are outside the scope of VAT as the charges are imposed for contravening the terms of an agreement or performing an unlawful act or breach of statutory obligations.

Examples: Speeding fine or fine for incorrect parking

Payment for Damaged Goods

If payment is made to compensate the damage or loss done by one party to the another or for breach of pre-existing terms of contract, VAT is not applicable as such payments are outside the scope of VAT.

However, as an exception to above if the customer has broken a product and is obliged to take title of the broken product, payment made by the customer represents consideration for the supply of goods and thus, VAT is applicable.

Conclusion

The clarification provides that to determine whether a payment should be treated as consideration for a supply or not, nomenclature or the labels related to the payments should be ignored. The parties should consider the contractual or legal arrangements and charge VAT accordingly.