Contractual penalty as a means of abuse of law

The Supreme Administrative Court (hereinafter the “SAC”), in its judgment No. 2 Afs 205/2024-37 issued on 10 September 2025, dismissed the cassation complaint regarding the reduction of the corporate income tax base by the contractual penalty paid.

This is a recurring case law on the issue of abuse of rights in the form of applying contractual penalties to the tax base, but this time the situation is assessed in greater depth, or rather from a different perspective. The subject matter of the dispute was whether the Company could reduce its corporate income tax base in the taxable period of 2014 by the contractual penalty of CZK 8,000,000 paid to it pursuant to Section 24(2)(zi) of Act No. 586/1992 Coll., on Income Taxes (“ITA”), or pursuant to Section 24(2)(zc) of this Act as in force until 31 December 2014.

What exactly was that all about?

The company established five subsidiaries (for photovoltaic power plants), which it financed. The Company obtained these funds through loans from its shareholders, loans from DEWPLAN and bank loans. The Company entered into a credit line agreement (including relevant amendments) with each subsidiary, under which the Company was to provide the funds drawn down by each of its subsidiaries through a loan. The company planned to repay its liabilities through repayments from its subsidiaries.

However, after the introduction of the solar tax, repayment problems arose. Subsidiaries paid less to the Company. The company then primarily paid off its debt to its shareholders, as it bore the highest interest rate. Repayments on the loan to DEWPLAN were not made on time. DEWPLAN subsequently assigned its receivables from the Company to KAVENGA. KAVENGA entered into a novation agreement with the Company, stipulating a contractual penalty of CZK 8 million if the Company fails to pay the interest for the relevant year in full by the 15th day of the following period (i.e., the penalty is applicable in full even if the Company owes, for example, only CZK 1 within the given period). Since the Company failed to pay interest in January 2014, it was assessed a contractual penalty of CZK 8 million, which the Company paid. The Company transferred this contractual penalty to its subsidiaries, with which it concluded amendments to the original credit lines. This means that the Company recorded a tax deductible expense of CZK 8 million in 2014 and at the same time taxable income of CZK 8 million.

What did the tax administrator or the court say?

The tax administrator did not recognize the inclusion of the contractual penalty in the Company’s tax expenses due to abuse of law.

The circumstances that weighed against the Company were, in particular, the following facts:

• the plaintiff prioritized repaying loans from partners, which had a higher interest rate but were not due and were not subject to such a high contractual penalty. The company argued that by repaying its partners, it saved CZK 2 million in interest, but the tax administrator found that by repaying the interest to DEWPLAN, the company would have saved only CZK 200,000 less in interest to its partners, but it would have avoided dealing with the consequences of breaching its obligations to other creditors. In general, it can be considered reasonable to pay off a debt with a higher interest rate if the obligations are otherwise comparable. However, the company gave absolute priority to the obligations of its shareholders, which does not make sense in terms of the resulting effect.
• the contractual penalty was disproportionately high, amounting to almost 90% of the annual interest,
• the contractual penalty entitlement was set at a fixed amount regardless of how much interest was not paid on time.

The tax administrator also suggested that the Company and DEWPLAN and KAVENGA might be otherwise related parties. But this was not proved in the end.

The SAC upheld the tax administrator’s view on abuse of law. The SAC held that the Company had abused the right and that the Company had thereby obtained a tax advantage (notwithstanding the fact that the effect on its tax base remained neutral due to the inclusion of the same fine in income), and it was irrelevant that it had recharged the fine to its subsidiaries. At the very least, the subsidiaries could not meet the subjective requirement of abuse of rights, which examines the purpose of the taxpayer’s conduct. The subsidiaries did not take part in the conduct in which the tax authorities perceived the abuse of law. How the taxpayer plans to dispose of the tax benefit is irrelevant. What is important is the fact that in order for the Company to be able to dispose of the tax advantage in this way, it had to obtain it.

The SAC also confirmed that Section 24(2)(zc) of the ITA cannot be applied to the case at hand. The contractual penalties paid are not a tax ineffective expense under Section 25 of the ITA (which is one of the conditions for the application of Section 24(2)(zc) of the ITA). The Supreme Administrative Court further confirmed that if the tax administrator concluded that the expense under consideration met all the formal conditions for deductibility under Section 24(2)(zi) of the ITA, yet did not assess it as tax-effective with respect to abuse of law, it is hardly possible to consider its deductibility on the basis of a somewhat subsidiary rule. Otherwise, the abuse of the right would be granted legal protection, albeit under a different, subsidiary provision. Ultimately, there would be no difference between when the taxpayer has abused the right and when it has not.

The SAC has therefore taken the abuse of rights a little further. The behaviour of a company must be considered as a whole. In this case, by paying debts to its shareholders (albeit high interest debts) and agreeing and paying a contractual penalty, the Company did not behave rationally and was found to have abused its rights.

It remains to be seen whether further judgments of the Supreme Administrative Court will follow the above-mentioned case law or whether a moderation can be expected.