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A contractual penalty may sometimes become a tax deductible cost

Supreme Administrative Court, II FSK 68/21

Ruling: The penalty on withdrawal from the contract may be a tax deductible cost after fulfilling all the requirement of becoming such. The Act on Personal Income Tax excludes from the category of tax deductible costs only specific types of penalties, so others may be deducted from taxable income.

Explanation: An entrepreneur operating in the farming industry decided to withdraw from a contract on delivering rye, as paying the contractual penalty was less harmful than performing the contract, that would lead to a large loss. They believed that the penalty should be treated as a tax deductible cost and in order to clear doubts, they have referred to the tax authorities. The response was negative, but the entrepreneur appealed to the administrative courts. The Voivodeship Administrative Court ruled in favor of the taxpayer, but the authorities appealed to the Supreme Administrative Court, claiming that the Act on Personal Income Tax excludes contractual penalties from tax deductions.

The Court rejected the administrations arguments and upheld the previous ruling. Article 21(1) of the Act on Personal Income Tax (its equivalent in the Act on CIT is Article 16(1)) rules out deductions of penalties arising from defects in delivered goods, performed works and services, and delay in delivery of goods free of defects or delay in removal of defects in goods or performed works and services. Therefore, penalties on withdrawal in general may be tax deductible. It is also unacceptable to claim, that a penalty on withdrawal is in essence a penalty on e.g. defects in performed services.

To make a deduction, those penalties must fulfill the criteria of tax deductible costs i.e. be an expense made in order to receive revenue or in order to preserve or protect a source of revenue.

Impact: The ruling of the highest administrative court of Poland should become a guidance for both the tax administration and courts when dealing with such cases. It also indicates, that courts notice the existence of extraordinary economic circumstances, under which refusing to perform a contract may sometimes be a necessity.