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:

• Is the payment a consideration for any previously agreed goods or services?
• Is the payment a consideration 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?
• Is there a promise not to exercise a right in return for payment?
• Is there a right being given up in return for payment?

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.