A general perception regarding VAT is that any payment that businesses made to each other should have VAT applicable on it disregarding the nature of payment. However the aforesaid perception is totally wrong. Federal Tax Authority has issued public clarification regarding applicability of VAT on compensation type payments but it can be applied to any situation where circumstances suggest that no supply of Goods and services has taken place.

Before commenting on the Public Clarification regarding compensation type payments lets understand what VAT is.

VAT is a tax applicable on the supply of Goods and Services or in other words it can also be stated that where there is no supply of Goods and Services there is no VAT.

Therefore in order to understand whether VAT is applicable on any payment, the main and only issue to define is that whether it is consideration for any supply of Goods and services or not. If the payment is consideration for any supply of goods and services VAT is applicable otherwise no VAT is applicable.

Federal Tax Authority presented certain examples for understanding of applicability of VAT on compensation type payments:

• Contractual Payment to compensate Loss

Liquidated damages in the most accurate example of compensation type payments where VAT will not be applicable.Liquidated damages are payments that one party agrees to pay other in case any of the terms mentioned in the contract are violated. For example if a particular job is not completed within the agreed time frame or the work does not meet the quality standards agreed. VAT will not be applicable in such situations as the payments are made to compensate the loss the other party may have suffer and not against provision of Goods and services.However payment made by a Guest to hotel for cancellation of Booking will have VAT applicable on it as this cessation of right that falls under the definition of provision of services.

• Payments Made for Settlement of Disputes

Where payments are agreed between the parties as a result of settlement of disputes it is important to consider the facts of the transaction in order to conclude whether VAT is applicable or not. For example

1. Where the payment is made to enforce a contractual term let’s say to agree to certain price or certain percentage of advance, such payments are as obvious against the Goods and Services mentioned in the contract and VAT is applicable.
2. Where payments are made to compensate damages as mentioned in Point 1 not VAT is applicable.
3. Likewise where payments are made to grant a right such payments will have VAT applicable on them, as granting of rights falls under the definition of supply of services.

• Payment of Fines and Penalties

Fines and Penalties imposed under Private Contracts and or by Government are for the purpose of compensation to other party or to punish someone for unlawful actions and not against providing Goods and services and therefore no VAT is applicable.

Summarizing in deciding applicability of VAT on compensation type payments or in any similar situation it is very important to understand the legal and contractual terms of the agreement. If the payment is against supply of Goods and Services only in that case VAT is applicable.