VAT on Compensation Payments

In the normal course of business, sometimes there will be payments in the nature of compensation for any loss, omissions, breach of contracts etc. Whether the payments on such compensation nature are taxable under the UAE VAT or not?
Recently the FTA has issued a public clarification (VAT P 001) related to VAT treatment on compensation type payments.

Tax Applicability on compensation type of payments:
The Basic rule as per the article 1 of UAE VAT law:
Taxable supply is defined as “supply of goods or services for a consideration by a person conducting business in the State and does not include exempt supply”. Hence, there should be a supply of goods or services in order to charge VAT. If any payment is not towards supply of goods or services, then such payment will not be considered as taxable supply.
Analysis:
In the case of compensation type payments, one has to analyse whether there is any supply involved on such transactions. Whether the payee has given anything in return for the payment? If there is any supply of service or goods involved on such payment, it will be a taxable supply. One has to exercise due diligence to determine whether the consideration is a payment against supply or is a compensation.
Here we are giving some of the situations which are compensatory payment in nature with an analysis to determine whether they are taxable or not.

Case 1.Payment to settle a dispute

If a dispute is settled between the parties and a payment is given to one of the parties, whether such payment is taxable or not? In order to decide whether such compensatory payment is a taxable supply or not, it is necessary to identify the reason behind the payment.

Payment to enforce a contractual term –
If a dispute is raised on the price of goods or services and a settlement decision is taken by paying a specific amount on the condition that the goods are to be supplied or services are to be provided on certain terms, such payments will be considered as against consideration and hence taxable.

Payment in the nature of damages or compensation for any loss –
Where a payment is in the nature of damages or compensation for any loss suffered by one of the parties normally the payment is not considered as against a supply of service or goods and hence not taxable.

Payment for loss of earnings:
Example : A & B agreed to construct a commercial property to complete within two years but was not completed on time. Dispute aroused, and compensation was agreed to pay on 50% of the loss of rental revenue for the delayed period of 6 months. It is a loss of earning and compensatory in nature. It is a compensation for loss suffered and hence not taxable.

Payment for granting a right
If the payment is against granting a right in such a situation the payment may be treated as consideration for the supply of right and hence will be treated as a taxable supply.
Example : One person agrees to allow to use a property by another and the second one makes the payment it will be treated as a taxable supply.

Case II: Payment to compensate for loss
Liquidated damages

Liquidated damages are the amounts which are declared in advance in the agreement for the party who will be incurring loss because of breach of any specific clause in the contract which is compensatory in nature for loss of earnings.
Example : The contract may specify that a compensation will be paid on early termination: A leased out a commercial property to B for a period of 12 months for an annual rent of AED 120,000/-. The terms of contract specify that if B terminates the contract before the expiry date of the tenancy contract, 2 months’ rent has to be paid as compensation. Hence, AED 20,000/- payment by B to A is not a taxable supply.

Compensation for Late Performance:
Example : A contract between A and B specifies that if the project is not completed within a period of two years, a compensation will be charged at the rate of 2% per month of the total project value.
In the above case, the payment is not given against any supply of goods or services but it is in the compensatory nature on loss of earnings and hence it is not a taxable supply.
Example : Normally the agreement by hotels with the guest includes a clause which specifies the terms and conditions on cancellation charges. If the booking is cancelled there will be a cancellation charge irrespective of the availability of the rooms. Cancellation charges are considered as cessation of a right and hence considered as a taxable supply.

Case III: Fine or Penalty

The Fine or penalty may be imposed by government bodies on:
Violation of agreement / breach of terms of a contract:
Example : A has got an exclusive distribution right from B for a particular product to distribute in the UAE. B has given distribution right to C in some other countries, however C supplies in some of the areas of UAE as well. The issue went into court and finally B has to pay a compensation to A for breach of contract. This will not be a taxable supply.

Doing an unlawful act: This kind of fines or penalties are not against supply of any service or good and hence are not taxable supplies.

Case IV: Payment against Damaged Good

The taxability depends upon the terms and conditions of the contract.
if the payment is a compensation and for breaking a pre-existing terms in the contract it will not be a consideration against supply and hence not taxable.

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