If any payment does not relate to a supply of goods or services then the payment is not subject to VAT. It is to determine by the tax payer whether the payment is against any supply, whether the payee has provided anything in return of the payment. If the payment is being treated as consideration against the supply of goods or services then the vat is chargeable.
Following are the situations to determine whether payment is compensation payment or consideration of supply payment.
1. Contractual payment to compensate for loss
Liquidated damages are predetermined amounts for an early termination of a contract or a late performance. The purpose of such payments is not to provide consideration for a provision of any goods or services but to compensate a party for loss of earnings. As such, the payments are outside the scope of VAT. However, 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.
2. Payment to settle a dispute
Where a dispute regarding a price of goods 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 for loss of earnings or a payment of interest in respect for a late payment of contractual consideration would not be a consideration for any supply. Such payments are out side the scope of VAT.
Where 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. Fine or penalty
A fine or penalty charge may be imposed for contravening terms of an agreement usually by government bodies, for breaches of statutory obligations. True fines and penalties are not consideration for any supply and therefore outside the scope of VAT.
4. Payment for damaged goods
Where a person has damaged or lost goods belonging to another person (for example, damaging a leased car), it may be required to make a payment to compensate for the damage or loss. It is unlikely to be consideration for a supply and therefore would be outside the scope of VAT.
In other case, where a customer breaks a good and is obliged to take title to it, the payment the customer makes would represent consideration for a supply of goods, and so would be subject to VAT.