The Federal Tax Authority (FTA) has recently published a clarification on VAT treatment of compensation type payments.

Our Associate, Sarra Alsamarrai summarized the examples of situations where the compensation payments may or may not give rise to a "supply" for a taxable purpose.

The Federal Tax Authority (FTA) has recently published a clarification on VAT treatment of compensation type payments, such as payments to settle disputes, and other contractually agreed compensation. Where a payment or fee is not a consideration for a supply, there is no VAT due. Often times, there are penalty clauses or liquidated damages clauses in a contractual agreement between two parties, and when triggered, it is unclear whether this is considered as a supply for VAT purposes.

Art. 2 of the Federal Decree-Law no. 9 of 2017 (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. Whether or not a payment is a consideration as per the VAT Law requires the taxpayer to consider the arrangements that give rise to the payment, and an analysis needs to be undertaken regarding the circumstances as a whole.

The FTA has provided examples of situations where compensation payments may or may not give rise to a “supply” for taxable purposes; below we have summarized the examples provided by the FTA:

1. Liquidated Damages and Compensation for Loss

Liquidated damages typically fall outside the scope of VAT since such type of payments do not provide consideration for any provision of goods or services; the purpose of liquidated damages is to compensate the party for loss of earnings.

However, where a contract offers a “cancellation charge” this would, in fact, fall under the scope of VAT, since such charges are considered as a cessation of a right for a supply of services. A typical example of this is where a hotel charges a cancellation fee.

2. Payments to Settle Disputes

When a payment is awarded to a party with reference to a dispute being settled, the exact reasons for the payment need to be analyzed. The following issues need to be considered:

a) Is the purpose of the payment to enforce a contractual term? If so, then it may be subject to VAT. For example, if the dispute relates to the price of goods, and payment must be made by the party to settle the price, then this will be considered as a supply of goods, and therefore subject to VAT.

b) Is the payment in the nature of damages or compensation for any loss suffered by a party? If so, then it may fall outside the scope of VAT. For example, payments of loss of earnings- this is similar to liquidated damages.

c) Is the payment in return for granting a right? If so, then it may be subject to VAT. For example, granting a right to use intellectual property in return for a fee. 

3. Penalties or Fines

Generally, fines and penalties are not considered as a supply and therefore fall outside the scope of VAT. The purpose of fines and penalties is to punish the wrongdoer, and the party imposing the fine is not making a supply for any service. Examples of this include a penalty for breach of contract or penalties imposed by government authorities. 

4. Payments for Damaged Goods

Payments to compensate for damaged or lost goods may fall outside the scope of VAT, especially so when the payment is compensation for breaching pre-existing terms of a contract. However, under other circumstances, it may be considered as falling within the scope of VAT; for example, if a customer breaks a good and is expected to pay for it and take title to the good.

Analysis

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. The following issues must be considered:

Most importantly, exact titles to payments being made may sometimes be misleading. For example, if a payment is labeled as a “penalty” or a “fine”, then it does not necessarily constitute a penalty. The exact reasons for the payment and the ramifications as such must be considered in full before concluding whether it constitutes as a supply for VAT purposes.