Director of National Income Information has recently issued two tax rulings on the deductibility for tax purposes of the costs of a lost suit. The rulings have two consecutive dates, with the first one, concerning corporate income tax, being in favour of the applicant, and the other one, concerning personal income tax, being adverse.
The first ruling, dated 28 June 2023, ref. 0114-KDIP2-2.4010.231.2023.1.SP, endorsed the interpretation offered by the applicant (a bank extending CHF loans), which was that the costs of a lost suit could be deducted by the bank for tax purposes. The ruling authority agreed with the applicant that the costs of a lost suit are reasonable and purposeful, given the bank’s business as such, and waived giving legal reasons for its conclusion. The bank on its part argued that the decision to engage in the lending business was a commercially valid, rational decision that was undoubtedly related to the bank’s business. Naturally, if at the time of entering into loan contracts there was a material risk of important contractual clauses being questioned, then a bank pursuing reasonable policies would not ultimately enter into such contracts.
Also, this is not a case where the applicant fulfilled its obligations in a wrong way. When the loan contracts when in force, the applicant duly performed its duties, both those arising from the contracts and those under generally applicable laws. At the same time, litigation costs cannot be part of the same category as contractual penalties or damages. There were no terms governing such costs that would be agreed contractually between the bank and its borrowers. Instead, such terms were imposed by a final judicial verdict, which means they cannot be treated as contractual penalties. Neither will such expenses qualify as damages because they are not a means to redress any loss or damage, including one arising due to a breach of contract.
Thus, the tax authority agreed with the applicant that its litigation costs serve the purpose of securing or preserving a source of its income (i.e. its lending business), arise from a specific judgment of court, and their deductibility is not excluded under Article 16(1)(22) of the CIT Act.
On the other hand, in the ruling dated 29 June 2023, ref. 0112-KDIL2-2.4011.461.2023.1.KP, the authority held that a taxpayer who has lost a suit and been charged with court costs and statutory interest may not treat those expenses as tax-deductible in its business. The case involved a sole trader engaged in motor trade who lost a suit filed by one of his clients based on a claim of latent defects in a car sold by him.
The ruling authority said that it is the taxpayer that incurs his business risk, which includes the risk of wrong decisions or failure to exercise due care, and thus is exposed to resulting business costs which he cannot simply compensate for by resorting to tax regulations as this would in fact mean that the risks of his business venture would be shifted onto the State Treasury. The deductibility for tax purposes of litigation costs and statutory interest would be contrary to Article 22(1) of the Personal Income Tax Act and to its precisely stated legislative purpose. The reason is that payment of litigation costs and statutory interest is not related to any real business transaction that would affect actual or potential income. Neither may it be considered to have been made in order to preserve or secure a source of income.
As such, the authority considered that the subject expenses were not incurred to preserve or secure a source of income, but are a result of a court judgment holding the trader to be at fault, i.e. they are a consequence of taxpayer’s inappropriate conduct. This means the expenses cannot be deductible by the applicant.
The two rulings clearly show that the tax authorities do not have a uniform approach to the deductibility of costs of a lost suit. Accordingly, each such expense should be carefully reviewed for whether it may be included in tax-deductible costs.
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