Termination fee can be a tax deductible cost if it allows taxpayer to increase profits

On July 25, 2024, the Director of the National Tax Information issued an individual tax ruling[1] confirming the right to recognize a fee for the termination of a real estate sales contract as a tax deductible cost.

What was the case about?

In the case under review, a real estate development company entered into a preliminary agreement for the sale of two entire residential buildings. In the course of the construction process, the demand for individual residential units increased significantly, due to, among other things, government support programs for borrowers. The company performed a profitability analysis, which showed that it would obtain a significantly higher margin by selling individual units in multiple transactions, instead of selling entire buildings in a single transaction in connection with the preliminary agreement.

The company agreed with the contractor to terminate the preliminary agreement, agreeing to pay a fee for withdrawing from the preliminary agreement. The amount of the fee was four times less than the expected increase in revenue from the sale of individual units compared to the sale of entire buildings. Thus, the fee was intended to make it possible to waive the obligation to exercise rights and claims under the preliminary agreement and to increase the company’s revenues. The fee did not result from the non-performance or improper performance of obligations under the preliminary agreement.

In an individual tax ruling, the Director of the National Tax Information confirmed the company’s right to recognize the fee as a tax deductible cost. The tax authority departed from preparing the justification and confirmed the correctness of the taxpayer’s position.

When is it possible to recognize the fee as a tax deductible cost?

According to the taxpayer’s justification, it is possible to recognize a fee as a tax deductible cost if the fee is reasonable and economically justified, taking into account the nature of the business activity. Thus, in order for a fee to be considered a tax deductible cost, it is important that the fee is reasonable from a business perspective, i.e. it could at least potentially lead to the generation of revenue, securing or preserving its source, even through the termination of a given business.

In the case under review, according to the taxpayer, the fee does not qualify as contractual penalties or damages excluded from tax deductible costs under Article 16(1)(22) of the CIT Act, since this provision covers only contractual penalties and damages on account of defects in goods delivered, work performed and services rendered, as well as delay in the delivery of goods free of defects or delay in the removal of defects in goods or performed works and services. Thus, not every contract termination fee is excluded from tax deductible costs.

In addition, the tax authority confirmed that the fee is a direct tax deductible cost, as it is closely related to the revenue that the company will receive from the sale of the units individually instead of the entire buildings. Therefore, the fee should be recognized as a tax deductible cost in the period in which the company receives revenue from the sale of the units.

Position of other tax authorities and administrative courts

The position adopted in the discussed tax ruling is in line with the views adopted in many other individual tax rulings and the prevailing case law line of rulings of administrative courts. They confirm that recognition of the termination fee as a tax deductible cost is possible if supported by economic rationality and business rationality, that is, the potential business benefits exceed the cost of the fee.

In our opinion, this approach is correct, as it focuses on the purpose of doing business, which is to maximize the benefits of the projects undertaken.

We point out that there are also opposing views, expressed in the minority by tax authorities, so there is a risk of challenging the right to recognize the termination fee as a tax deductible cost, even if it would make economic and business sense. However, if such a tax ruling is challenged, a positive line of jurisprudence for taxpayers prevails in the administrative courts.

Summary

In view of the increasingly positive approach of the tax authorities, we recommend reviewing the fees incurred to date and considering this issue in any future fees for termination or amendment of contracts from the perspective of their tax deductibility.

We would be happy to assist you in this process.

[1] Individual tax ruling dated July 25, 2024, ref. no. 0114-KDIP2-2.4010.266.2024.1.AS.