Public clarification (VATPO01)- Compensation Type payments

Posted By Admin   -   Posted On Feb 28, 2019

In Accordance to Federal Decree-Law No. (8) of 2017 on Value Added Tax, tax is imposed on goods or services supplied against a valid consideration. However, there are some payments made by businesses to compensate against loss, damaged goods or penalties. The question arises that how these payments shall be construed when applying VAT.

The FTA’s recent public clarification for compensation type payments addresses this query. The Public Clarification provides that in cases wherein payment is not made as consideration for a supply of goods or services, the obligation to pay VAT on such supply does not arise.

With the help of this clarification, the FTA has laid down the following principles that should be used to determine if VAT should be due on compensation payments. There are four types of payments covered under this clarification which are as follows:

1. A contractual payment to compensate for loss:

The best example for such a payment can be “liquidated damages” which are decided between two entities at the time of signing a contract. These contractual payments are supposed to be paid in case of termination of a contract or late performance. As the purpose of the above-mentioned payments is not to provide consideration for a provision of any goods or services, but to compensate a party for loss of earnings, VAT is not applicable on these payments.

It is pertinent to note that contractual payments to compensate for a loss do not include the cancellation charges, charged by the hotel for cancellation of a booking, irrespective of the room being available to the guest or not, since the charges are taken for cessation of a right, which is a supply of service by the hotel and thus, chargeable to VAT.

2. A payment to settle a dispute:

According to the public clarification (VATPO01), where a payment has been made to settle a dispute, it is important to consider the reason behind such payment to determine the VAT implications. Following are the cases which can be seen for VAT understanding:

Cases Discussed Treatment of VAT
Where payment is made to enforce a contractual term. Since this payment is a consideration for a contractual supply, VAT is applicable.
Where a payment is in the nature of damages or compensation for any loss. This payment is not consideration for any supply. Hence VAT is not applicable on it.
Where a payment is in return for granting a right. This payment is consideration for the supply of the right and may be subject to VAT.

3. Fine or Penalty:

According to the public clarification (VATPO01), VAT shall not be applicable on fines and penalties, as the charges are imposed for disregarding the terms of an agreement or performing an unlawful act or breach of statutory obligations.

4. Payment for damaged goods:

Where a person has damaged or lost goods belonging to another person (for example, damaging a leased car), he may be required to make a payment to compensate for the damage or loss. Where the payment is made to reimburse for the losses done by one party to another , or for breach of pre-existing terms of contract, VAT shall not be applicable, as such costs are outside the scope of VAT.

However, where a customer damages some goods and is obliged to take title to it, the payment the customer makes would represent “consideration for the supply of goods”, and so would be subject to VAT. This example provides us an exception to the basic rule mentioned above.

In short, the Public Clarification describes various scenarios to illustrate the basis of making such a determination and indicates where the FTA shall draw the line regarding what constitutes genuine compensation. Businesses, which impose fines or penalties on customers, should review the current VAT treatment applied to such income in light of this release in order to determine whether any corrective action is required. We at SENAT MEA are committed to giving you solutions regarding your tax and VAT queries. In case you need further details, feel free to contact us at info@senatmea.com.

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