The FTA through Public Clarification VATP001 has laid down the principles that the businesses can use to determine if the VAT should be due on compensation payments.

In order for an obligation to charge VAT to arise, there must be a supply of goods or services. If any payment does not relate to a supply of goods or services then the payment is not subject to VAT.

The question of whether or not a payment is consideration for a supply is the matter of fact. 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.

As part of business arrangements, businesses will often make payments to compensate each other for any loss, omissions or other wrongdoings.

The following are several examples in which a payment may or may not be made in exchange of a good or service.

These are few examples it does not cover all types of payments that might be made in such situations, but give an example of principles that should be used in determining whether VAT should be due on compensation-type payments.

1 – A contractual payment to compensate for loss

An example of such a compensatory payment are “liquidated damages”. Liquidated damages are amounts that was predetermined by parties to an agreement during the formation of the agreement for compensate the injured party upon a specific breach For example,

– Terminating a contract,
– Late performance

The purpose of such payments is not to provide consideration for a provision of any goods or services but to compensate any damages that have occurred. 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. This is regardless of whether the hotel room remains available to the guest or not.

2 – 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 to determine the VAT treatment.        

 For example:

– Where a payment is made to enforce a contractual term, the payment is consideration for the contractual supply to which it relates. For example, where a dispute regarding goods that supplier has already supplied but they have not received the amount in return for this supply, 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.

– Where a payment is in the nature of damages or compensation for any loss suffered by a party, the payment is not consideration for any supply and is outside the scope of VAT. for example, late payment penalty. The late payment penalty is going to be received by the service provider not in exchange of any goods or services provided, and therefore, this particular payment is outside the scope of VAT.

– 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 its property (including intellectual property) in return for a payment, the payment is consideration for the supply of the right to use the property.

3 – A fine or penalty

A fine or penalty charge may be imposed on people not for an exchange of goods or services, but for contravening terms of an agreement, performing an unlawful act or for breaches of statutory obligations. and by that, such payments are outside the scope of VAT.

For example:

– It is clearly mentioned in a contract between two parties who have entered into an agreement, that if any party does not perform his duty in the agreed way, or if late deliveries have taken place, or whatever kind of breaches, then a penalty shall be imposed on the same party. Such payments are clearly not made in exchange of any good or service and therefore, is 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 or fine for incorrect parking imposed on a car driver, and therefore paid a penalty to the government authorities. The authorities have not provided any good or service to the car driver in that case and therefore, shall not charge VAT on the payment as it is outside the scope of VAT.

4 – Payment for damaged goods

Where a person has damaged or lost goods belonging to another person, it may be required to make a payment to compensate for the damage or loss. For example Where two parties A & B have entered into an agreement, in which A will lend a property owned by them to the B, and the B returns the property with a damage to A and it is clearly mentioned in the contract that a specific amount is to be paid by B if there is any damage in the property. In that case the amount that is to be paid by B for damaging the good is not made in return for any good or service, and therefore shall not be subjected to VAT as it is outside the scope of VAT. For example, damaging a leased car.

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. For example, a description of an administrative payment as a “penalty” or a “compensation” will not prevent the nature of the payment from being consideration for a supply.