From this article you will learn:

• What is excluded from tax deductible costs under CIT?
• Are contractual penalties expenses related to business activity?

The possibility of including contractual penalties in tax costs has been a bone of contention between the tax office and taxpayers for many years. According to the tax office, penalties resulting from contracts cannot be included in tax costs because they do not meet the basic criterion – they do not serve to raise revenues or secure a source of revenues. Taxpayers, however, believe that failure to pay the contractual penalty would lead to incurring or increasing a loss – which means that it is clearly related to the revenues achieved. Who is right and why?

The essence of the dispute over contractual penalties 

In "ordinary" CIT, tax costs cannot include contractual penalties and compensation for defects in the goods delivered, works and services performed, as well as delays in the delivery of defect-free goods or delays in removing defects in goods or works and services performed. The legislator explicitly excluded this type of penalties and compensation from tax-deductible costs. Taxpayers therefore argue that the remaining penalties – since they were not taken into account by the legislator – can be included in tax costs. 

In Estonian CIT, taxable income is income corresponding to, among others, the amount of expenses unrelated to business activity. And it was the connection between the expense incurred to pay the contractual penalty and the business activity that became the source of the dispute between taxpayers and the tax office. 

Contractual penalties in Estonian CIT 

A company dealing in the acquisition of land and its sale for commercial purposes submitted a request for an interpretation to the Director of the National Tax Information regarding contractual penalties in Estonian CIT. 

It sometimes happens that – due to delays or failures in the execution of orders – the above-mentioned company pays contractual penalties to contractors and customers. These penalties are imposed, among others, due to failure to meet the deadline of the contract with the electricity supplier, sale of land to a third party or delays in the provision of services. 

According to the company, the fines it pays are expenses related to its business activities. The fact that in the classic CIT these types of penalties were excluded by the legislator from tax costs does not mean that they are subject to tax in the Estonian CIT. The Director of the National Tax Information did not agree with the company's position: she argued that expenses incurred to pay contractual penalties should be treated as side costs – i.e. those that do not serve to generate profits, but are of a sanction nature and result from incorrect actions, so as such they cannot be considered business expenses. 

The Provincial Administrative Court in Poznań, in its judgment of 25 January 2024 (file ref. no. I SA/Po 632/23), agreed with the company's opinion. According to the court, the concept of costs that are not tax-deductible costs is not the same as the concept of expenses unrelated to business activity. The court emphasised that, in the case in dispute, the costs incurred by the company to pay contractual penalties are expenses related to business activity and as such are not subject to Estonian lump sum taxation. 

Do (and how) contractual penalties affect taxation in Estonian CIT? 

As the example described above shows, the tax office has a very restrictive approach to the issue of contractual penalties, but it is profitable for taxpayers to defend their opinions and assert their rights in courts. However, when using favorable judgments in the Estonian CIT case, we should remember that each case should be analysed individually, because the relationship between the expense and business activity is often determined by nuances. Achieving the intended result may require the involvement of experienced tax advisors, but the amount of contractual penalties paid is often so significant that it is definitely worth taking such a step and taking up the gauntlet in a dispute with the tax office.