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Any payment done specific to the notice period could come under a VAT purview. Image Credit: Shutterstock

An employment contract between an employee and employer is outside the scope of VAT. This is a universally recognized principle and always mentioned in the VAT legislation.

Although the UAE VAT Law does not specifically define employment contracts as outside the scope of VAT, the Taxable Person Guide clarifies this. Under the UAE VAT Law, a supply must be made by a person conducting business - i.e., any regular or ongoing activity conducted with a degree of independence and continuity. Due to the requirement that a business must be an independent activity, the activities of employees are not treated as being in the course of business.

As such, employees are not liable to charge VAT on their remuneration or salary. Having said that, there are certain transactions between the employee and employer that occur outside the employment contract.

Liable for recovery

An organisation may recover from an employee: visa charges for dependents, personal mobile expenses, insurance of employee dependents, vehicle usage charges, etc. We will discuss the VAT treatment of recoveries made by organisations in lieu of employees not serving their full notice period.

When an employee resigns, in the normal course of business, the employee must serve a notice period, as may be mutually agreed in the employment contract. During the notice period, he or she should be present on all the working days.

In certain situations, the employee may not want to serve all or part of the notice period. In which case, either the employer waives off the requirement of servicing the entire notice period, or the employee may be asked to pay an amount equivalent to the salary of the unserved notice period. The question that arises is whether the money received by the organisation for the unserved notice period constitutes consideration for a ‘supply’?


Article 119 of the Employment Law provides that if the employer or the employee has failed to serve notice to the other party for termination of the employment contract, the party obliged to serve the notice period shall pay to the other party compensation known as ‘compensation in lieu of notice’ equal to the pay for the unserved notice period. Such compensation is payable even if such failure to notice or such reduction of the period does not cause damage to the other party.

From a VAT perspective, one may be tempted to refer to the VAT Public Clarification on VAT Treatment of Compensation-type payments issued by the Federal Tax Authority (FTA). The Guide clarifies that:

  • A fine or penalty may be imposed for contravening the terms of an agreement.
  • Where a person has caused damage to another person, the person causing damage may be required to make a payment to compensate for such damage or loss.

The Guide provides that fines and penalties are not a consideration for any supply, and therefore outside the scope of VAT. Also, where the payment is compensation for breaching pre-existing terms of a contract, it is unlikely to be a consideration for a supply and therefore outside VAT’s scope.

If one were to closely read the provisions of UAE Employment Law, the compensation is payable even if such failure to notice or such reduction of the period does not cause damage to the other party. Therefore, one could argue that compensation in lieu of an unserved notice period is not a fine or payment in lieu of damages. It is to be seen if the FTA will refer to the provisions of employment laws to evaluate whether a payment is a fine or a payment in lieu of damages.

One may note that the UAE VAT Regulations define ‘Supply of Services’ to include cessation or surrender of a right. In the case of notice pay recovery, one may argue that the organisation is giving up its right to an employee serving the notice period, in lieu of consideration, and hence the same would be taxable at 5 per cent.

Not swayed by descriptions

In considering whether a payment is a consideration for a supply or is in the nature of penalty, it is important to ignore the labels or titles given to a payment. A description of a receipt as ‘penalty’ or ‘compensation in lieu of damages’ will not prevent the nature of the payment from being considered for a supply.

The VAT treatment of recovery of notice pay must be considered in conjunction with the rights of the employer, employee, employment contract and the local labour laws. There may not be a universal answer, and each situation must be evaluated on its own facts.