Last updated: October 2026
When a client cancels a project and agrees to make an additional “compensation” payment, the finance team must decide whether UAE Value Added Tax (VAT) applies, whether to issue a tax invoice, and whether tax already reported for the original transaction needs to be adjusted.
The description in the agreement does not answer those questions. Three facts matter: whether the payment settles goods or services already supplied, whether it compensates for loss caused by a breach, and whether the payer obtains a termination right, release, or other undertaking in return.
One termination payment can contain components with different VAT treatments. Identify each underlying transaction before deciding the tax treatment. Do not treat the entire amount as taxable, and do not exclude the entire amount merely because the agreement calls it “compensation”.
Compensation for loss of income can fall outside the scope of VAT
The UAE Federal Tax Authority’s VAT Treatment of Compensation-type Payments (VATP001) requires the full contractual and legal arrangement to be considered when determining whether the recipient gives anything in return for a payment. Labels such as “compensation”, “penalty”, or “settlement payment” do not determine the VAT result by themselves. (Source: UAE Federal Tax Authority, VAT Treatment of Compensation-type Payments (VATP001), June 2018; subject to the latest official publication.)
Qualifying Liquidated Damages can compensate a business for income lost because of a contractual breach. If the payer receives no additional goods, services, rights, or undertakings in return, the amount may fall outside the scope of VAT. The relevant loss is not confined to costs already incurred and paid. A loss of income can also support this treatment where it has a contractual basis and a documented causal connection to the breach.
A calculation based on the service fees for the remaining months of a contract does not determine the payment’s VAT character on its own. The same calculation method could estimate lost income, represent unpaid consideration for services, or price a right to exit the contract early. The business must still examine the breach, the extent to which the original supply was performed, the basis of the loss calculation, and what each party obtains or surrenders after payment.
A spreadsheet cannot carry the entire classification. The contract terms, reason for termination, evidence of loss, and changes in the parties’ rights must all describe the same economic event.
Rule out consideration for the original supply before assessing new rights or undertakings
After a project dispute, the parties may include unpaid amounts for completed services in a single settlement figure. If a payment still settles goods or services already supplied, it may remain consideration for the original supply. Renaming it as a settlement payment does not break that connection.
The termination arrangement may also create a new exchange. The client might pay for an early exit, while the supplier agrees to release an obligation, terminate a right, waive a claim, or refrain from exercising a right. These are identifiable rights or undertakings that may amount to a supply of services. A mutual-release clause does not automatically create a new taxable supply. The analysis still has to establish a direct link between the payment and the undertaking, and then determine the VAT treatment of the resulting supply. (Source: UAE Federal Tax Authority, VAT Treatment of Compensation-type Payments (VATP001), June 2018; subject to the latest official publication.)
For each amount in a termination agreement, the parties should establish whether it:
- recovers consideration for goods or services already supplied;
- compensates for a documented loss of income caused by a breach; or
- pays for a termination right, release, waiver, or other undertaking.
All three relationships can exist in one agreement, but they do not have to. The invoicing treatment must follow the relationship supported by the transaction documents.
Separate line items do not automatically mean separate supplies
Writing a settlement total as three line items does not prove that there are three supplies for VAT purposes. Before allocating the amount, the parties must determine whether each component is an independent supply, a non-supply matter, or part of a single composite supply that cannot properly be divided.
Article 46 of the UAE VAT Executive Regulations requires the contract and the transaction as a whole to be considered when deciding whether several components form a Single Composite Supply or multiple supplies. If an arrangement is a single composite supply with a principal component, its VAT treatment follows that principal component. Where no principal component exists, the treatment follows the nature of the supply as a whole. (Source: UAE VAT Executive Regulations, Article 46, September 2026; subject to the latest official publication.)
Allocation comes later. Once the total is shown to cover independent components that require separate treatment, Articles 25–26 must be considered to determine whether the Market Value rules apply—for example, where the consideration relates both to a supply and a non-supply matter, or to different supplies. (Source: UAE VAT Executive Regulations, Articles 25–26, September 2026; subject to the latest official publication.)
The sequence matters: identify the supply relationship, determine whether the arrangement contains one supply or several, and only then decide whether allocation is required, which basis applies, and how each component should be invoiced and reported. Separate amounts in the agreement do not justify a mechanical allocation, while one total amount does not mean Market Value allocation always applies.
The distinction between independent items and a composite supply, as well as any allocation basis, depends on the complete contractual arrangement. A tax professional should review these points before the agreement is signed.
Tax invoices and Tax Credit Notes should follow the adjustment
Compensation for loss that is not consideration for a supply should not be covered by a VAT tax invoice merely because the business receives money. The business should still retain the termination agreement, loss calculation, payment evidence, and accounting records.
If the amount settles the original supply, it follows the VAT treatment of that supply. An amount already invoiced should not be invoiced again because the parties later use a different description. Where the termination or settlement changes the original consideration, the business should compare the settlement with the original tax invoice, VAT return, and required adjustment.
When the original consideration decreases and the statutory conditions are met, the supplier issues a Tax Credit Note and adjusts the corresponding Output Tax. The recipient of the goods or services reduces the related Input Tax in the tax period in which it receives the Tax Credit Note. Where the original consideration increases, the supplier should issue the required additional tax document and adjust Output Tax under the applicable rules. (Source: current UAE VAT Decree-Law, Articles 61–63 and 70, October 2026; subject to the latest official publication.)
If a payment for a new right or undertaking constitutes a supply of services, the parties must identify the supplier, recipient, consideration, date of supply, and VAT treatment before deciding which tax document is required. The classification of the transaction, the correct tax document, and the relevant tax period cannot be determined from an agreement summary alone. They require tax-professional review against the current legislation and the complete transaction file.
Make the contract, calculation, and accounting records tell the same story before signing
Waiting until finance receives the signed termination agreement often leaves too little room to correct the drafting or assemble evidence. During negotiations, the original contract, work completed, original invoices, breach event, loss calculation, and changes in rights should be reviewed together.
A reviewable record should answer six questions:
- What did the original contract require the supplier to provide, and which parts were completed and invoiced?
- Why did the project end, and how did the claimed loss arise and how was it calculated?
- Does the payment supplement, replace, or adjust the consideration for the original supply?
- Which rights do the parties obtain, terminate, or surrender after payment?
- Are the components independent matters or part of an indivisible composite supply?
- Do the original invoice and VAT return require a new invoice, a Tax Credit Note, or a tax adjustment?
Before signing a termination or settlement agreement, Schedule a 30-minute complimentary assessment to map the reason for the payment, the changes in rights, and the invoicing points that require tax-professional review.
A project may end, but the VAT relationship between the original supply and the subsequent payment does not disappear with a change in the agreement’s label.
This content is for informational purposes only and does not constitute legal or tax advice. For professional consultation, please contact the MIRISE team.