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The COVID-19 pandemic continues to have a heavy impact on the global economy. The spread of the virus is constraining the supply and demand for goods and services. As a result, companies are considering the potential cancellation of contracts and the impact on their cash flows.

In this special edition of the Middle East Tax Newsletter, we set out the VAT aspects of the potential cancellation of contracts. We also provide suggestions to optimize cash flow positions from a VAT perspective.


If either party cancels a contract, there cannot be a supply from a VAT perspective. Therefore, if the supplier had already issued an invoice for the supply of goods or services, the supplier will be required to issue a credit note to the customer. The supplier can then offset the output VAT on the credit note against the VAT payable for the relevant period.

Any payment made in consequence of a cancellation may however still be subject to VAT. This depends on the nature of the payment for the cancellation, including whether there was a supply of goods or services.

The UAE Federal Tax Authority (FTA) has clarified, in its first Public Clarification, its view on the VAT treatment of compensation type payments. The FTA states that liquidated damages to compensate a party for the loss of earnings is outside the scope of VAT. However, a payment to enforce a contractual term may be subject to VAT. Cancellation fee payments are generally subject to VAT whilst “true” fines and penalties are not. Companies should analyze their contracts to determine whether the supplier has provided the goods or services in return for the payment.

Optimizing cash flow

To understand the impact of VAT on cash flow, it is important to know that VAT is due with respect to each VAT return for the period in which the supply of goods or services took place. The supply takes place on the earliest of the i) date of issuance of the tax invoice; ii) date of payment; or iii) date the goods or services are provided. If a supplier/taxpayer issues the tax invoice in a VAT return period that is earlier than the period when it receives the payment, the supplier/taxpayer would be pre-financing the VAT. This is because the supplier would have to pay the VAT before it would have received the payment from its customer. There are several ways for a supplier/taxpayer to optimize its cash flow from a VAT perspective.

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To speak to us in relation to any tax issues in the Middle East, please feel free to contact one of the lawyers below, or your usual Baker McKenzie contact.

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