Right to tax the cessation of right: VAT implications on liquidated damages


KT file photo
KT file photo

Taxability of hotel cancellation charges, in particular, has been a complex issue internationally, and different countries have different tax positions on the issue

By Pankaj S. Jain

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Published: Fri 21 Jan 2022, 6:28 PM

“Don’t go, skip the golf tournament and lunch,” I asked my wife, as she planned to meet her old office colleague, “what about our hotel reservation in RAK?”

“Let’s plan that some other time,” she replied.

As I cancelled the booking, the hotel charged VAT on the cancellation charge and that made me curious, because the hotel services were never supplied as we did not visit the hotel.


Value Added Tax (VAT) is a tax on supplies of goods and services. VAT is not applicable if no supply takes place. Businesses often receive and/or make payments. If a payment is not the consideration for a supply, VAT is not applicable on such transactions. The underlying reason for the payment should determine the VAT implications.

Public Clarification

The very first public clarification by the Federal Tax Authority (VATP001) in June 2018 was on compensation type payments. The clarification is very detailed and provides the criteria to determine whether or not a payment is consideration for a supply. It is important to consider whether:

- the payment is consideration for any previously agreed goods or services;

- the payment is consideration for any newly created supply of goods or service

- the purpose of the payment is to adjust a previously agreed consideration for a supply;

- a party is granting a right to another party in return for a payment;

- a party is promising not to exercise a right in return for a payment;

- a party is giving something up in return for a payment.

Liquidated Damages

One such case is of liquidated damages. Liquidated damages are predetermined amounts agreed in an agreement as compensation upon a specific breach e.g. for an early termination or a late performance. Liquidated damages are outside the scope of VAT as its purpose is to compensate a party for loss of earnings.

However, the hotel cancellation charges are treated differently. The clarification states that the cancellation charges are taxable. The reason is that such charges are considered a cessation of a right which are a supply of services.

The concept of ‘cessation of a right’ in taxation has been intriguing since time immemorial. Every contract is essentially a set of rights & obligations between the parties to the contract. It is the cessation of contractual rights that often causes loss of earnings to a party.

To illustrate, if a client cancels a retainership contract with a consultant, the cancellation causes loss of earnings to the consultant and the consultant ceases his/her contractual rights. Similarly, an early cancellation of a contract for post-paid mobile causes loss of earnings to the telecom operator. But the penalty (say, one month rental) could be treated as cessation of rights by the telecom operator. Such penalties are no different than the hotel cancellation changes.

The clarification mentions that the labels/titles give to a payment must be ignored e.g. a description of an administrative payment as a penalty/compensation will not prevent the nature of the payment from being consideration for a supply.

International Jurisprudence

Taxability of hotel cancellation charges, in particular, has been a complex issue internationally. Different countries have different tax positions on the issue. Some countries also differentiate between predefined cancellation charge (which is not taxable) and ‘no-show’ charges (which is taxable). The European Court of Justice has also taken different views at different points in time.


The moot question is whether all liquidated damages for a breach of contract will be taxable? A simple answer would be no.

However, businesses need to ensure that the nature of payment is correctly determined. If a payment, even if labelled as penalty, is for a cessation of right then such payment could be subject to VAT.

“I wonder if notice pay recovery from the employees are also a cessation of right?” she asked.

“Let us discuss it over coffee in this biting cold weather.” I said as we walked down to the café.

The writer is the managing director of AskPankaj Tax Consultants. For feedback and queries, you may write to info@AskPankaj.com. Views expressed are his own and do not reflect the newspaper’s policy.

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