As explained in the Federal Decree Law No. 8 of 2017 on Value Added Tax (“VAT Law”), VAT is imposed on payments that are in return of taxable supplies of goods or service. As per the VAT Law, the term “taxable supplies” refers to supplies of goods or services inside the state that are not including exempt supplies.
This means, that in order to charge VAT on a payment received, the payee must supply in return to the payer goods or services worth of what the payee received. If no supply of goods nor services is made in return to the payment received by the payee, then the payee is not permitted to charge VAT on the payment amount received.
In order for the payer to understand whether the payment they are making must include VAT or not, they must analyze if they are receiving any good or service in exchange of what they are paying.
The following are several examples in which a payment may or may not be made in exchange of a good or service.
*Note: Tax payers must understand that the below examples are not the only cases of such arguments, there are many other cases, and tax analysis must depend on case-by-case analysis when the subject is “compensation-type payment”.
1- A contractual payment to compensate for loss
An example of compensation payments is “liquidated damages”. Liquidated damages amount is an amount that parties of the contract have agreed on, in which the injured party will receive the amount to compensate the breach that has occurred. For example,
- Terminating a contract,
- Late delivery.
The purpose of such payments is not to provide another good or service, but they are just to compensate any damages that have occurred because of the occurred incident, and therefore, such payments are outside the scope of VAT.
2- A payment to settle a dispute
Where a dispute is settled, and an amount is paid to one party, it is necessary to understand the nature behind the payment in order to determine the VAT treatment on such payments. The following are different scenarios,
- If the payment is made for the supplier to enforce a contractual term. For example, the supplier has already supplied what they have promised to supply but they have not received the amount in return for this supply, and a payment dispute has taken place then. This payment that will be made to the supplier after the dispute will be done for the goods or service supplied in the first place, which means that the amounts paid to the supplier are in return for goods or services, which makes the payment subject to VAT.
Where a payment is made to compensate losses suffered by the service provider, 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 made to grant right, then the payment made will be in exchange of the right itself, and might be subjected to VAT. For example, a person is paying an amount of money to a property owner in exchange for the right to use the same property for a year. In that case, the payment is made in exchange of the right to use the property.
3- A fine or penalty
A fine or penalty may be imposed on people not for an exchange of goods or services, but for a breach of rules and regulations, 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 imposed on a car driver who has exceeded the maximum speed limit 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 two parties have entered into an agreement, in which the 1st party will lend a property owned by them to the 2nd party, and the 2nd party returns the property with a damage to the 1st party and it is clearly mentioned in the contract that a specific amount is to be paid by the 2nd party if there is any damage in the property. In that case the amount that is to be paid by the 2nd party 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.
However, it is always important to analyze the reason behind every payment made, and only by that, the payer will know if their payment is subjected to VAT or not.
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