The obligation to disclose major shareholdings
July 2021 – Compensation for damages is not subject to VAT. VAT is only due on the price paid for the supply of goods or services. Compensation for damage is not included in this... or at least not always.
Compensation for damage is excluded from the scope of VAT
The instructions of the tax authorities are clear: "Compensation for damage actually suffered is not (...) the consideration for a taxable transaction. This compensation is limited to making good the damage or punishing the non-performance of an obligation.
There can be no VAT payable without an operative event, namely the actual supply of goods or services.
The tax authorities themselves give a series of examples of such compensation for damages.
The deposit paid by a hotel guest: the deposit is not the consideration for the provision of a service (it is not the consideration for the reservation and the stay in the hotel has not yet taken place). If the service (stay) is provided, the deposit is deducted from the price. In the event of cancellation, the hotelier keeps the deposit. No VAT is due on this deposit.
In the event of termination of a business contract, the part of the compensation that covers the entrepreneur's loss of profit is not subject to VAT. The part of the compensation relating to services already provided or goods already delivered is, however, obviously subject to VAT.
Compensation for damages is subject to the same VAT regime as the provision of services
The examples in the VAT commentary all refer to situations where the damage arises from the failure of one of the parties to fulfill its part of the contract.
But there are also contracts which literally leave it to the parties to perform the contract for a certain consideration... or not, but in this case in exchange for compensation.
If this compensation for non-performance is provided for in the contract, can we still talk about compensation for damages?
The Court of Justice has already indicated on several occasions that if the contract gives the customer a choice, the VAT consequences cannot be influenced by this choice.
Telecommunications contracts
In 2017, the Court of Justice of the European Union ruled in a Portuguese case that compensation for early termination of a telecommunications contract was indeed subject to VAT. The reason was that customers could benefit from a lower tariff if they remained customers for a certain period. In case of early termination, a fixed amount of compensation was due. This compensation was not insignificant: the telecom provider was entitled to the same amount as it would have received if the customer had not terminated the contract early. And the Court held that this "compensation" or "fine" was subject to VAT. The Court thus wanted to avoid the application of a different VAT regime depending on whether or not the contract is performed to completion.
In another case, the Court of Justice of the European Union went even further. This case also concerned telecommunication contracts in which customers committed themselves for a minimum period. If they did not comply with the contract, compensation was due which corresponded to the costs that the telecom provider would have for the current period. So not the full price as in the Portuguese case, but only an indemnity for the costs. Also in this case, the Court ruled that the compensation is subject to VAT because it must be considered as consideration for the provision of services.
Your penalty clause
These judgments seem to have two connecting factors.
The compensation covers at least the "damage" suffered by the service provider.
The compensation is fixed as a lump sum according to certain criteria.
It seems therefore that if you have not included any clause in your contract, or if the extent of the damage caused by the breach of contract has to be established, the compensation in question is really considered as compensation for damages.
If, on the other hand, the compensation is fixed at a lump sum, the Court sees the compensation as consideration for a service rendered, whether or not it is performed.
The safest option therefore seems to be to specify from the outset in your contract whether or not you will apply VAT to your penalty clause. In this case, there is no longer any room for discussion.
