VAT on Penalties - Real Estate Sector

The issue of amounts received by taxpayers from their clients that are in the nature of penalty are contentious and have always attracted debate. Depending on the contractual terms inter se the parties, such amounts could be considered as both taxable/exempt or Out of Scope.

In the context of Real Estate companies, the tenants are quite frequently charged various amounts typically arising when the tenant either cancels the contract before the expiry of its term (early termination fee) or when the tenant delays renewal of agreement (late renewal fee). It could potentially become difficult to exactly interpret how the FTA would assess these situations considering that some may think these amounts to be punitive in nature and thus, Out of Scope. Whereas, some others could interpret it as a consideration for additional work that the landlord has to do and therefore, it becomes a VATable supply.

In some of the private clarifications issued by the FTA, it has been observed that the above amounts have not been interpreted to be in nature of a penalty, rather these have been considered as a consideration towards a VATable supply. These are not considered as penalty for loss of profits, rather an amount received for a service. Though, the taxpayers have contested such amounts Out of Scope as they are in the nature of penalty for breach of contract and thus, loss of profits that the landlord would have earned if the contract had remained valid until its expiry.  The FTA rather considers these as a fee for the additional administrative work done by the landlord. The facts of each taxpayer, though could lead to different interpretations.

Typically, any income derived by the landlords which appear to be in the nature of penalty (i.e. not charged by the landlord in normal circumstances) could potentially be towards a service and thus, subject to VAT.  Unless the landlord is absolutely clear that the amount is towards a breach of contract and the payments are compensatory in nature, detailed assessment of each such revenue stream should be made to ensure correct tax treatment.