Compensation for damages, indemninity payment, penalty forfeit in the light of the VAT act

Liquidated damages or fee to be refunded

In our legal practice we have often experienced that the contractual partners of our clients do not pay the penalty stated in the contract on the grounds that no invoice has been issued. Sometimes there are also disputes between the contractual parties whether the penalty stated in the contract is a gross value including VAT or nor.

The basis of the disputes is that the Act on Value Added Tax (VAT Act) – in contrast to compensation for damages – does not lay down a concrete provision on penalty. This fact encourages lawyers or tax specialists encountering the problem to explore the legal nature of penalty following the understanding of which it becomes obvious that no value added tax (VAT) should be paid on penalty and accordingly no invoice should be issued for it.

In order to be able to fully explore the above mentioned complex problem we will examine the obligation to pay VAT and to issue an invoice on the payment of compensation for damages, indemnification and forfeit.

In simplified terms and with certain exceptions: taxable persons shall be subject to VAT if they supplied goodsand services for consideration within the domestic territory (Section 2 a) of the VAT Act). Under the VAT Act, supply of services is any transaction which does not constitute a supply of goods (Section 13 (1) of the VAT Act). In addition – inter alia – supply of services also covers the obligation to tolerate an act or situation (Section 13 (2) b) of the VAT Act). For this reason, if someone is obliged to tolerate an act or situation he/she does supply services. If the person receives consideration for the supply of services, he/she will be liable for payment of the VAT.

Consideration shall mean anything of value to be exchanged to settle a debt, including the value accepted for the reduction of existing claims, but not including compensation for damages (Section 259 (6) of the VAT Act. The VAT Act expressis verbis excludes compensation for damages from the definition of compensation, thus its payment does not generate obligation to pay VAT. Given the fact that the VAT Act does not include any provisions relating to the other three legal instruments (indemnity payment, penalty, forfeit), the VAT payment obligation can be deduced from the general legal criteria of compensation for damages.

Under the Civil Code, the person who causes damage to the other party by breaching the contract (contractual liability) or who causes damage extra-contractually to another person wrongfully (delictual liability) shall be liable for such damage. The starting point is that liability for damages is incurred only in case of unlawful conduct (under the other legal conditions). No one is obliged to tolerate unlawful conduct, thus it cannot be considered as supply of services. As there is no supply of services (toleration of unlawful conduct), we cannot speak about payment of the consideration in the case of compensation for damages. Rightly recognising the above, the legislator emphatically excluded compensation for damages from the definition of consideration.

Contrary to compensation for damages, indemnification always presumes excusable damage caused by lawful conduct. We can regard payment for excusable damages as consideration because: (i) the VAT Act does not exclude it from the definition of consideration, (ii) it can also be deduced from the interpretation of the definitions that the party obliged to tolerate the lawful conduct causing damage (aggrieved party) constitutes supply of services with the toleration itself. In this case, the person causing the damage shall pay to the party who suffered damage for the right to exercise lawful conduct (and at the same time compensation for the passive conduct of the aggrieved party).

Penalty and forfeit can be considered as the reflection of compensation for damages and indemnity payment provided for by the parties in the contract according to the definitions of the notions of lawful-unlawful (noting that penalty may be enforced under provisions on compensation for damages). Penalty can be stipulated in writing in the case of breach of contract, i.e. the case of unlawful conduct. Penalty, as well as compensation for damages, is of a sanctionary nature, thus it cannot be considered as consideration. In contrast, forfeit constitutes compensation because the party lawfully exercising the unilateral termination of the contract actually “buys” the possibility of the termination of the contract with the forfeit. Therefore, forfeit is a supply of services, the financial compensation for tolerating the termination of the contract by the other party, in other words it is consideration for (the right to) release from contractual obligation.

In summary, no VAT shall be paid on payment of compensation for damages and penalty whereas the payment of indemnity and forfeit constitutes an obligation to pay VAT. In the case of indemnity and forfeit that are subject to VAT, an invoice shall be issued under Section 159 (1) of the VAT Act whereas in the case of compensation for damages and penalty it is enough to issue a receipt under Section 166 of the VAT Act.

The information contained in this website should not be construed as legal advice on any matter or a substitute for legal counsel and it does not necessarily represent the official opinion of the Sárhegyi & Partners Law Firm. As a matter of policy, Sárhegyi & Partners does not accept a new client without first obtaining a written and signed engagement letter.

Because the law changes constantly, the information contained in this website may or may not reflect the most current legal developments; accordingly, information on this website is not promised or guaranteed to be fully applicable in the present circumstances of each individual matter and it is also possible that under the current developments, the effective courts and authorities come to a different legal position in their verdicts or settlements in concrete cases.

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