The Federal Tax Authority, FTA, has issued a public clarification regarding tax treatment of compensation-type payments, noting that value added tax, VAT, is imposed on supplies of goods and services and if any payment does not relate to a supply of goods or services, then the payment is not subject to VAT.
The Authority noted that as part of business agreements, businesses usually make payments to compensate each other for any loss, negligence or other errors. VAT should not be applied to such amounts if they do not relate to a supply.
In a recent press statement, the Federal Tax Authority noted that under Article 02 of Federal Decree-Law No. 08 of 2017 on Value Added Tax, VAT is imposed, among other things, on taxable supplies of goods and services. Taxable supply is defined in Article 01 of the same Law as a "supply of goods or services for a consideration by a person conducting business in the UAE and does not include exempt supply".
The Authority had issued these statements in a Public Clarification on VAT Treatment of Compensation-Type Payments, published on its website. The Clarifications are the latest of the FTA’s various instruments used to raise awareness among tax payers about the technicalities of the tax system.
FTA Director-General, Khalid Ali Al Bustani, said, "We seek to offer the new ‘Public Clarifications’ service in a simplified and accurate manner, where it can be accessed through the Federal Tax Authority’s website by clicking the ‘Getting Help’ tab."
"This service helps spread tax awareness among businesses and consumers alike, providing useful information about tax laws, executive regulations and tax procedures, leading to a successful implementation of the tax system," he explained. "This information is regularly updated, and the Authority additionally provides a series of educational short films, workshops and awareness campaigns targeting all sectors."
The Authority explained that to determine whether or not a payment is considered a supply, it is necessary to consider the contractual and legal arrangements in full to determine the reason for the payment. Thus, it may be necessary to consider whether the payment is consideration for any previously agreed goods or services; if it is consideration for any newly created supply of goods or services; if the purpose of the payment is to adjust a previously agreed-upon consideration for a supply; if a party is granting a right to another party in return for a payment; if a party is promising not to exercise a right in return for a payment; or if a party is giving something up in return for a payment.
In considering whether a payment is consideration for a supply or is in the nature of compensation, it is important to ignore the labels or titles the parties give to a payment, the FTA continued, citing as an example that describing an administrative payment as a "penalty" or a "compensation" will not prevent the nature of the payment from being consideration for a supply, and therefore potentially subject to VAT.
The Authority listed a number of situations where a payment may or may not be treated as being consideration for a supply of goods or services, noting that the list did not seek to provide answers for all types of payments, but to give an example of principles that should be used in determining whether VAT should be due on compensation-type payments.
An example of such a compensatory payment are "liquidated damages", which are predetermined amounts that parties to an agreement designate during the formation of the agreement for the injured party to collect as compensation upon a specific breach – for example, for an early termination of a contract or a late performance. The purpose of such payments is not to provide consideration for a provision of any goods or services but to compensate a party for loss of earnings. As such, the payments are outside the scope of VAT. That does not, however, include where a contract allows a hotel guest to cancel a booking in return for a cancellation charge, as such charges are considered a cessation of a right, which are a supply of services and hence subject to VAT.
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 to determine the VAT treatment. 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. Meanwhile, 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, and therefore not subject to VAT. On the other hand, if a person agrees to allow another person to use his/her property (including intellectual property) in return for a payment, the payment is consideration for the supply of the right to use the property, and is therefore subject to VAT.
Regarding payment for damaged goods, the Authority pointed out that 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, the payment may 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 then represent consideration for a supply of goods, and so would be subject to VAT.
The Federal Tax Authority cautioned that an administrative penalty or fine may be imposed for contravening terms of an agreement, performing an unlawful act or otherwise be imposed, usually by government bodies, for breaches of statutory obligations. True fines and penalties are not consideration for any supply and therefore outside the scope of VAT.
The Authority went on to explain that a contract may stipulate that a party must make a payment if it breaches a term of the contract. 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.
When a fine or penalty is imposed by a government authority for an unlawful act – for example, a speeding fine or fine for incorrect parking – the purpose 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.