On January 17, 2012 the Supreme Administrative Court held that companies in breach of passenger car leases may treat liquidated damages due upon earlier termination of operation lease agreement as a deductible operating expense when the car was used by a board member who was later removed (court file no II FSK 1365/1310).
The Court enumerated several factors in determining what constitutes an operational expense. The Court looked at whether (1) the expense that was incurred is actual amount, (2) whether it is related to the economic activity, (3) whether it was incurred in order to obtain revenue, maintain or protect revenue sources and (4) whether it was properly documented and has not been excluded on the basis of the Article 16 paragraph 1 of the Corporate Income Tax Act.
The Court further held that factor most heavily weighted in the determination of whether liquidated damages may be regarded as an operational expense is whether it “was incurred to obtain revenue, maintain or protect revenue sources”. An expense will not be disqualified as an operation expense on the lone grounds that the company did not achieve the desired economic effect (revenue production). The court reasoned that where a reasonable and rational economic decision was made in clear connection to revenue production, after a negative change in circumstances a party may need to take actions to maintain or protect revenue sources. The concept of this fact need not be in expenses incurred in order to “maintain or secure sources of revenue”. It is important to assess the expenditure as the tax cost and take into account the logical sequence of events that cause specific actions of the taxpayer (the conclusion of lease contract, changing economic conditions, the reasons for withdrawal from the contract resulting in a payment of liquidated damages) and their impact on the achievement of revenue, maintenance or protection of revenue sources, as well as the dynamics of economic processes and phenomena in which occurs the change of initially taken decisions, and that this change is associated with maintenance or protection of revenue source.
The Court has made it clear in its decision that contrary to some previous glossary and jurisprudence, under the current provisions of law the taxpayer paying liquidated damages or compensation is generally acting in order to obtain revenue. Liquidated damages or compensation may have a relationship with the revenue, not to mention the view of maintaining or securing sources of revenue. In addition, the execution of an existing obligation by payment of a penalty or compensation is not always associated with a reduction in income.
In the present case from an economic point of view, breaking the lease agreement and payment of a penalty was beneficial both for the taxpayer (as the income reached was higher than possible to achieve in case of continuation of the lease agreement) and for the State Treasury (as from the higher income the taxpayer will pay a higher tax).