Contractual penalty is not always a tax cost
The contractual penalty replaces the compensation for non-performance or improper fulfillment of the terms of the contract. The parties to the contract, in order to secure their own interests, may define the manner of compensation in the event of failure to comply with the joint arrangements. Therefore, entrepreneurs often face the problem of whether liquidated damages can be recognized as tax deductible costs. Let's check.
Contractual penalty and tax deductible costs
The regulation of the contractual penalty can be found in the Civil Code in Art. 483-484.
Pursuant to the provisions, the parties may stipulate in the contract that the compensation for the damage resulting from non-performance or improper performance of the obligation will be made by payment of a specified amount (contractual penalty). In addition, the debtor may not release himself from the performance of the obligation by paying a contractual penalty.
The question arises whether the payment of the contractual penalty will result in an expense classified as tax deductible costs?
The rules for including expenses in tax deductible costs are specified in Art. 15 sec. 1 of the Corporate Income Tax Act (hereinafter: the CIT Act) and, respectively, art. 22 sec. 1 of the Personal Income Tax Act (hereinafter: the PIT Act). They show that the tax costs will be expenses incurred in order to achieve revenues or to maintain or secure the source of revenues, with the exception of the costs listed in art. 16 sec. 1 of the CIT Act (Article 23 (1) of the PIT Act, respectively).
Failure to comply with the contract and contractual penalty in the company's costs
Following the provision of Art. 23 sec. 1 of the PIT Act, it should be assumed that the contractual penalties paid, resulting from improper fulfillment of the provisions of the contract, are not recognized as tax deductible costs. The taxpayer could avoid this cost if he complied with the terms of the contract. Such a position was taken, among others, by Provincial Administrative Court in Szczecin in its judgment of June 14, 2013 (file reference number I SA / SZ 88/13). The court considered the application of the company which included in the tax costs a contractual penalty for improper fulfillment of the terms of the contract for the provision of medical services in the field of healthcare, imposed by the National Health Fund. The justification stated that there was no doubt that the expense was not incurred in order to generate income. If the taxpayer had correctly fulfilled the terms of the contract, he would not have been charged a contractual penalty. The imposed penalty was of a sanctioning nature.
In the individual ruling of 16 January 2017, ref. No. 0461-ITPB1.4511.1023.2016.1. PSZ issued by the Director of the Tax Chamber in Bydgoszcz, we can read: "(...) The provision of Article 23 (1) (19) of the Personal Income Tax Act states that contractual penalties and compensation for defects in the delivered goods, works and services and delay in delivery are not deemed to be tax deductible costs. goods free from defects or delay in removing defects in goods or performed works and services. (...) contractual penalties from tax costs This provision does not cover cases of untimely performance of works.
Thus, not all contractual penalties resulting from non-performance or improper performance of the contract do not constitute a tax cost, but only those penalties resulting from defects in the goods sold, defects in the works and services performed, penalties for delay in replacing the defective goods with defective ones or penalties for delay in removing defects in the works and services performed. (...) "
The position taken by the Director of the Tax Chamber clearly indicates the possibility of including the paid contractual penalties as tax costs, despite the fact that the contractual penalties were listed in the catalog of non-tax deductible expenses. When classifying an expense as costs, particular attention should be paid to the reason for imposing a contractual penalty.
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Jan Kowalski runs the XYZ company and provides construction services. Due to unfavorable weather conditions, he did not meet the terms of the contract, as construction was completed 3 weeks after the agreed deadline. The Principal imposed a contractual penalty on Mr. Jan due to the untimely performance of the works. Can Mr. Jan include the contractual penalty imposed on him in the tax costs?
As a rule, contractual penalties have been included in the catalog of expenses not included in tax deductible costs. However, in a situation where the reason for imposing a contractual penalty is untimely fulfillment of the contract, it is possible to include the penalty in costs. Mr. Jan may include it in the costs, because the contractual penalty for delay is not related to the penalty for defective performance of works, and thus has not been mentioned in Art. 23 of the PIT Act.
Contractual penalty imposed on the contractor in connection with defective performance of works
Pursuant to the applicable regulations, contractual penalties imposed in connection with defective performance of works cannot be counted as tax deductible costs. However, there are doubts when the defect arose for reasons beyond the contractor's control, as the work was performed with materials with manufacturing defects. If the company performing the work, in accordance with the provisions of the contract, was obliged to purchase the necessary materials, it is responsible for their completeness and defectiveness. In a situation where, after the work is done, the buyer discovers defects in the materials used, he may issue a debit note to the entity that performed the work and demand that the defects be removed. The justification for this is Art. 556 of the Civil Code, according to which, if the sold item has a physical or legal defect, the seller is liable to the buyer. This is called warranty.
Art. 5561 § 2. The Civil Code:
If the buyer is a consumer, the public assurances of the manufacturer or his representative, the person who places the item on the market within the scope of his business activity, and the person who by placing his name, trademark or other distinctive sign on the item sold are treated equally to the seller's assurance. presents himself as the producer.
Despite the fact that the defectiveness of the works performed was the fault of the producer and not the negligence of the taxpayer providing the services, he is obliged to pay the imposed contractual penalty.
Jan Kowalski runs the construction company XYZ and provides roof maintenance and replacement services. He performed the service for another entity, using for this purpose the tiles he had purchased under the contract. A week after the service, Mr. Jan received a debit note due to the defect of several tiles, which resulted in a leak in the roof and the destruction of the floor in one of the rooms. In a situation where the damage resulted from a manufacturing defect in the material used, is Mr. Jan obliged to replace the defective tiles? Can the paid contractual penalty constitute a tax deductible cost?
Pursuant to Art. 561 § 1 of the Civil Code, if the sold item has a defect, the buyer may require the seller to replace the item with a defect-free one or to remove the defect. Therefore, Mr. Jan should repair the roof by replacing the defective tiles. In addition, the contractual penalty paid does not constitute a tax cost, as the tax deductible costs do not include contractual penalties for defects in the goods delivered and the performance of works.
Contractual penalty - summary
In summary, the recognition of contractual penalties in Art. 23 of the PIT Act is not tantamount to the inability to classify them as tax deductible costs. When classifying the incurred expenses as tax costs, one should first of all pay special attention to their cause. As a rule, liquidated damages imposed in connection with faulty performance of works or delivery of defective goods are not included in tax costs.However, if the entrepreneur receives a contractual penalty due to untimely fulfillment of the terms of the contract, he may include it in company costs, because this type of contractual penalty has not been excluded from the catalog of expenses included in tax deductible costs.