VAT Treatment on Compensation Type Payments

Article 2 of the Federal Decree Law no. 9 of 2017 on VAT Law states that VAT is imposed on taxable supplies of goods and services. “Taxable Supply” is defined as a supply of goods or services for a consideration by a person conducting business in the UAE and does not include exempt supplies. Where a payment is not consideration for supply, no VAT is due on the payment.  But what about payments made by businesses to compensate each other for any loss?Question is whether VAT is due on such payments.

Analysis

In order for an obligation to charge VAT to arise, there must be a supply of goods or services. If any payment does not relate to a supply of goods or services then the payment is not subject to VAT.

However, question of whether or not a payment is consideration for a supply is the matter of fact.This requires the taxpayer to consider the underlying arrangements that give rise to the payment in order todetermine whether the payee has provided anything in return for the payment or not.

The FTA has provided examples of situations where compensation payments may or may not give rise to a “supply” for taxable purposes. Few examples are summarized below:

1. Contractual payment  -Predetermined amounts that parties agree upon contract formation for the injured party to collect as compensation upon a specific breach. This can be subdivided into two categories:

• Liquidated damages

The Purpose of payments against liquidated damages  is not to provideconsideration for provision of any goods or services but to compensate a party for loss of earnings. Assuch, these payments are outside the scope of VAT.This can include

• Cancellation Charges

In case a contract allows a hotel guest to cancel a booking in return for acancellation charge, such charges are considered a cessation of a right, which are a supply of servicesand hence subject to VAT. This is regardless of whether the hotel room remains available to the guest or not.

2. Payment to settle a dispute - In this situation, we have to consider the reason behind the payment made in order to determine the VAT treatment. For example:

• Contractual Term Payment

Where a payment is to enforce a contractual term, the payment is a consideration for the contractual supply to which it relates. For example, where a dispute regarding a price of goods is settled by requiring a contractual recipient of the goods to make a payment for these goods, the payment will be consideration for the supply of the goods and therefore subject to VAT.

• Payment against loss/damages

Where a payment is in the nature of damages or compensation for any loss suffered by a party, the payment is not consideration for any supply and is outside the scope of VAT. For example, a payment for loss of earnings or a payment of interest in respect for a late payment of contractual consideration would not be a consideration for any supply.

• Payment for granting a right

Where a payment is in return for granting a right then the payment is consideration for the supply of the right and may be subject to VAT. For example, a person may agree to allow another person to use its property (including intellectual property) in return for a payment; the payment is consideration for the supply of the right to use the property.

3. A fine or penalty

• Breach of contract

Payment made as a result of a breach of a contract is in the nature of damages and therefore outside the scope of VAT.

• Fine imposed by a government authority for an unlawful act

For example, aspeeding fine or fine for wrong parking. The purpose of such fines is to punish the wrongdoer forthe act and the party imposing the penalty is not making any supply in respect of the payment.Therefore, no VAT is due on such fines and penalties.

4. Payment for damaged goods

Where a person has damaged or lost goods belonging to another person ( for example, damaging a leased car), it may be required to make a payment to compensate for the damage or loss.

Where the payment is compensation and for breaching pre-existing terms of a contract, it is unlikely to be consideration for a supply and therefore would be outside the scope of VAT.

In other circumstances, there is likely to be consideration for a supply – for example, where a customer breaks a good and is obliged to take title to it, the payment the customer makes would represent consideration for a supply of goods, and so would be subject to VAT.

The FTA has emphasized that legal and factual circumstances must carefully be assessed in order to determine whether compensation payments can be considered as a supply for VAT purposes or not.The following issues must be considered:

• Is the payment a consideration for any previously agreed goods or services or for a new supply of goods or services?
• Is the purpose of the payment to adjust a previously agreed supply?
• Is there a right being granted in return for payment or there a promise not to exercise a right in return for payment?

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