In the normal course of business, people might have to deal with compensation-type payments due to various situations or as per the terms of contracts. Compensation-type payments refer to payments made to compensate for loss, damage, or other disruptions in business agreements. These could include penalties for breach of contract, settlements for damages, or compensation for early termination of contracts. Understanding whether these payments are subject to VAT is essential for businesses to ensure compliance and thereby avoid penalties. This blog aims to give some insights into the VAT implications of compensation-type payments in the UAE VAT law.
Let us start by learning what a taxable supply is. What criteria should be met for a supply to become taxable?
A taxable supply is defined in the VAT legislation as a “supply of goods or services for consideration by a person conducting business in the UAE and does not include an exempt supply”. Therefore, for a supply to be a taxable supply, the following conditions would generally need to be met:
- There needs to be a supply of goods or services.
- The supply has to be for consideration, and
- The supply has to be made by the person who is conducting business in the UAE.
Taxable supplies may either be subject to the standard rate or zero rate of VAT. A supply cannot be a taxable supply if it is an exempt supply. Where a supply is neither a taxable supply nor an exempt supply, it will be outside the scope of UAE VAT.
Where a taxable person makes a “taxable supply” of goods and services, it will typically be required to account for VAT to the FTA. For a taxable supply to exist, the supply must be made in return for consideration. “Consideration” is a defined term in the VAT legislation and includes anything that is received or expected to be received for the supply of goods or services, whether in money or other forms of payment.
If any payment does not relate to a supply of goods or services, then the payment is not subject to VAT (Out of scope). However, it is a bit challenging to know whether to classify a payment as a compensation-type payment or not. Generally, for a supply to become taxable, it should be a transfer of goods or services with consideration by a person conducting business in the State, excluding exempt supply. So, to identify the compensation-type payments we need to look at the nature of it.
Typically, this requires the taxpayer to consider the underlying arrangements that give rise to the payment in order to determine whether the payee has provided anything in return for the payment. Below, several situations are considered where a payment may or may not be treated as being consideration for a supply of goods or services. It should be noted that the purpose of this discussion is not to provide answers for all types of payments that might be made in such situations but to give an example of principles that should be used in determining whether VAT should be due on compensation-type payments.
Examples are.
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- A contractual payment to compensate for loss – when a taxable person breaches a contract in any way, it is a loss of earnings for the party. The taxable person is paying this money not in exchange for any consideration but for the loss which is incurred because of this person. These types of payments are compensation-type payments that are out of scope in 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 is a supply of services and hence subject to VAT. This is regardless of whether the hotel room remains available to the guest or not.
- Payment to settle a dispute – generally when a taxable person pays something to settle a dispute, it seems like compensation given to the party. However, it is important to know the backstory of the payment to understand whether it is taxable or out of scope. If the dispute was to decide the price of some goods we received, or it’s the price of any right of use we received, then the settlement payment would be considered as a consideration as the dispute was for settling the invoice amount for the goods and would be taxable.
On the other hand, if the dispute was based on some loss or damage faced by the party, then the settlement payment is not a consideration as it is paid without any supply of goods or services. These types of payments would be out of scope. An example of these types of payments can be a late payment penalty.
Where a payment is in return for granting a right then the payment is consideration for the supply of the right and may be subject to VAT. For example, a person may agree to allow another person to use their property (including intellectual property) in return for a payment, the payment is consideration for the supply of the right to use the property.
- A fine or penalty – a fine or penalty is charged when a taxable person breaches the statutory obligations imposed usually by the government. Such penalties or fines are never in respect to any supply of goods or services and, therefore, would be outside the scope of VAT. Example: Traffic fines.
Sometimes a contract may stipulate that a party must make a payment if it breaches the term of the contract. The payment made because of a breach of contract is in the nature of damages and therefore also outside the scope of VAT.
- Payment for damaged Goods – if a taxable person has damaged goods, and is compensating for the damage caused, there is no supply of goods or any consideration which makes it fall out of scope. on the other hand, if a person has damaged goods and is obliged to take responsibility or title for the damage caused, then there is a supply of goods in this which makes it subject to VAT.
In a nutshell, to identify whether a payment made was a compensation-type payment or not, we can check for the following.
- The payment is a consideration for any previously agreed goods, or it is a payment for any newly created supply of goods or services. If yes, then it’s taxable. If not, then it has to be treated as out of scope.
- The purpose of the payment was to adjust a previously agreed consideration for a supply. If yes, then it’s taxable. If not, then it has to be treated as out of scope.
- A party is granting any right in return for the payment. If yes, then it’s taxable. If not, then it has to be treated as out of scope.
- A party is giving up something in return for the payment. If yes, then it’s taxable. If not, then it has to be treated as out of scope.
The VAT treatment of compensation-type payments in the UAE is depends on the nature of the payment. Generally, compensation payments made for genuine damage or for breach of contract are not subject to VAT, as they are not considered a supply of goods or services. However, if the compensation payment is connected to a supply, such as a cancellation fee or an early termination charge, it may be subject to VAT.
It is crucial for businesses to carefully assess the nature of compensation payments to determine the correct VAT treatment. Misclassifying these payments can lead to non-compliance with UAE VAT regulations, resulting in potential penalties. Consulting with tax professionals or the Federal Tax Authority (FTA) for specific cases is advisable to ensure accurate VAT treatment.
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