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Payment according to an out-of-court-settlement and tax deductible costs

2015-08-11

Qualification of a payment made for the benefit of a contractor as a payment for waiver of claims on the basis of an out-of-court-settlement as a tax deductible cost may give rise to doubts on the part of tax authorities, which as a rule take the position that such expenditures should be individually investigated whether they fulfil the general definition of tax deductible costs.

According to tax provisions, the incurred expenditures can be considered tax deductible costs provided that the following conditions are satisfied:

  • the expenditure is incurred in connection with business activity that is carried out,
  • there is a link between the expenditure and generation of revenue (retaining or securing the source of revenue),
  • the legislator has not clearly excluded the given expenditure from deductible costs.

The fact that the expenditure incurred according to the out-court-settlement takes place in connection with the business activity that is carried out should not give rise to any doubts. At the same time, payment for waiver of claims for damages according to the out-of-court-settlement has not been indicated in the CIT Act as an expenditure that does not qualify as a tax deductible cost.

However, the reason for a dispute with the tax authority may be determining whether there is a cause and effect relationship between incurring an expenditure the tax payer under the settlement and generating revenues, retaining or securing the source of revenues by the tax payer.

An argument against such a cause and effect relationship is the fact that the out-of-court settlement is reached in order to put an end to the dispute and  minimize the costs (losses) that the company would have to incur in case of a negative resolution of the litigation procedures. The tax authorities claim that solely taking actions that aim at reducing the depletion of assets do not automatically translate into activities that are aimed at securing the, source of revenues (vide: the sentence of the Supreme Administrative Court from 20.07.2011, ref. II FSK 460/10).

The argument which supports the thesis that this kind of relationship does exist could be the will of the parties to continue the cooperation in the future in order to achieve mutual benefits, which is confirmed by specific provisions of the settlement reached by the parties – for instance, regarding discounts granted in future transactions. If the tax payer proves that the main aim of the out-of-court-settlement is to enable further cooperation and generate revenues in the future, it will be possible to treat the expenditure in the form of a payment for waiver of claims as a tax deductible cost. It is crucial to prove that the conclusion of the out-of-court settlement is in the economic interests of parties and allows bringing a long-term litigation to an end, which in an indirect manner enables the tax payer to focus on activities that generate profits (and not carrying on litigations).

In-court-settlement of a litigation with a contractor regarding compensation can not only be expensive, but also time-consuming. It is advisable to analyze tax risks and to include in the out-of-court-settlement some provisions regarding the connection of the expenditures with present and future revenues of the tax payer while negotiating the content of the out-of-court-settlement.