Principle to Determine VAT Treatment:
The FTA through Public Clarification VATP001 has laid down the following principles that the businesses can use to determine if the VAT should be due on compensation payments:
- A Contractual Payment to Compensate for Loss
The most common type of compensatory payment is Liquidated damages. This is the payment made to compensate a party for the loss and it is not in relation to the supply of any goods or services. Therefore, such types of compensation are outside the scope of VAT. Examples include early termination of a contract or a late performance.
- A Payment to Settle a Dispute
Where a dispute is settled (e.g., in or out of court) and a payment is awarded to a party, it is necessary to consider the reason behind the payment in order t determine the VAT treatment. For example,
- In cases where a payment is made to enforce a contractual term, VAT is applicable as payment is a consideration for the contractual supply
- Where the payment is made as compensation for any loss, the FTA won’t consider the payment as a consideration for the supply and therefore it is outside the scope of VAT in the UAE.
- In cases where a payment is made in return for the grant of a right, the payment will be treated as consideration for the supply and therefore VAT is charged.
- A fine or penalty
True fines and penalties are not a consideration for any supply and therefore outside the scope of VAT. For Example,
- The payment made as a result of a breach of a contract is in the nature of damages and therefore also outside the scope of VAT.
- A fine or penalty may be imposed by a government authority for an unlawful act – for example:
- a speeding fine
- fine for incorrect parking.
The purpose of such fines is to punish the wrongdoer for the 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.
- Payment for damaged goods
If the payment is compensation for the damage or loss of goods or breaching the pre-existing terms of a contract, it won’t be treated as consideration for a supply and therefore is outside the scope of UAE VAT.
However, if a customer breaks a good and is required to take the title of the broken good, then the payment made by the customer would be treated as a consideration for a supply of goods, and hence would be subject to VAT.
In summary, in determining whether or not a payment is a consideration for any supply, it is necessary to consider the contractual and legal arrangements in full to determine the reason for the payment.
Source: Federal Tax Authority