Early contract termination not always subject to VAT

In a judgment of 17 May 2024 (ref. I FSK 1240/20), the Supreme Administrative Court (NSA) ruled that fees charged in the event of termination of a contract due to the client’s fault perform a compensation function and are not subject to VAT. The NSA justified the above position with the lack of identifiability of the consideration, as the company terminates the agreement as a result of breaches by the client. There is no additional consideration, so there is no VAT.

This is an interesting judgment by the NSA, since so far the authorities and administrative courts have, as a rule, considered contractual penalties and other such fees due for early termination of a contract to be subject to VAT. However, it is worth noting the important factual elements that prejudiced the taxation of VAT. For example, in the judgment of 7 October 2020 (ref. I FSK 22/18), the NSA ruled that a contractual penalty for early termination of an agreement by a franchisee constitutes remuneration in exchange for the provision of a service (consent to early termination of a franchise agreement) within the meaning of Article 8(1)(2) of the VAT Act and, therefore, is subject to VAT. The remuneration arises from the concluded agreement and the provision consists in the toleration of the premature termination of the agreement by the franchisor in exchange for the agreed remuneration, and therefore constitutes the provision of a service for consideration. In this case, there is no discussion of the compensatory nature of the payment, as both parties agree to the early termination of the contract and the payment of additional remuneration for this.

Similar positions on the taxation of contractual penalties and other such claims for early termination of a contract can be found in individual tax rulings (e.g. 0111-KDIB3-1.4012.1040.2021.3.ASY of 1 June 2022 and DOP7.8101.4.2022.HEMD of 30 January 2023).

Description of the case

In the Supreme Administrative Court judgment in question (I FSK 1240/20 of 17 May 2024), the company provided construction support services, including the rental of construction machinery and equipment. The contract specified contractual penalties, including a charge for theft or loss of the rented machine, a charge for early termination of the contract due to the fault of the customer and a contractual penalty for delay in returning the rented machine. The taxpayer asked the authority whether the above fees / contractual penalty were subject to VAT. The Director of the National Tax Information (KIS) ruled that the fee for the theft/loss of the machine was not subject to VAT, while the other two fees shall be. The taxpayer challenged the ruling issued and it was overturned by the Voivodship Administrative Court . The NSA upheld the judgment of the first instance and ruled that the fees / contractual penalties in question are of a compensatory nature, therefore the amounts paid out in this respect are not subject to VAT.

It should be emphasized that in the case considered by the NSA, the fee for early termination of the contract due to the fault of the customer did not result from a mutual agreement to amend the provisions of the contract or an agreement between the parties, but from its unilateral termination by the company as a result of significant irregularities committed by the customer. The company terminates the contract and charges fees / penalties regardless of the customer’s opinion. The fee and contractual penalty for the delayed return of the rented machine are not remuneration for agreeing to the early termination of the contract, but compensation for the damage caused by the customer – the customer does not receive any benefit from it.

The described NSA judgments indicate that in order to assess whether a contractual penalty for early termination of a contract should entail additional VAT obligations, an in-depth analysis of the circumstances of the obligation to pay the contractual penalty is necessary in each case. As can be seen, depending on the circumstances, this type of payment can sometimes be considered as remuneration for a service and sometimes as compensation not subject to VAT.