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Penalties: Deductibility
VIOLATION of laws, contracts or policies has become inevitable due to the complexities of this modern world. Violations, intentionally or unintentionally, occur in transactions between or among private individuals or entities or in dealings or transactions with the government. And for some of these violations, penalties in various forms may be imposed.
Some of the penalties are agreed upon by the parties, especially in private transactions, but others are imposed by laws. For transactions with the government or for non-compliance with an obligation required by the government, penalties are usually defined by the law or the rule imposing the obligation.
For taxpayers, payment of penalty would mean additional expense. But is this additional expense deductible for income tax purposes? As a rule, payments made in the course of trade or business are deductible. However, special rules apply to payments of penalties or fines.
Our jurisprudence is clear regarding the deductibility of penalties paid to government agencies for violation of the law or other governmental obligations. In one case, the court held that fines and penalties paid for the late payment of taxes are nondeductible expenses. The court decreed that when acts are condemned by the law and their commission is made punishable by fines or forfeitures, to allow them to be deducted from the wrongdoer’s gross income, reduces, and so in part defeats, the prescribed punishment.

The Bureau of Internal Revenue (BIR) also held in one ruling that penalties imposed for late payment of statutory contributions are not ordinary or necessary business expense, and so not deductible from gross income under the Tax Code. According to the BIR, expenses that are ordinary and necessary generally contemplate expenses that are directly connected with and proximately resulting from carrying on the business and must be shown to be appropriate and helpful in the development of the taxpayer’s business for the acquisition or pursuit of income or profit. Evidently, penalties paid to government agencies for violation of laws are nondeductible.
Penalties of this type are deemed not ordinarily and necessarily incurred in the conduct of a taxpayers’ trade or business. Thus, it is nondeductible even if the violation is accidental or if the violation is required for the good of the business. Allowing such payment as a legitimate deduction would in any way sanction the repetition of the illegal acts or violations ought to be deterred. With regard to the penalties imposed for violations of contractual agreements, the income-tax regulations provide that, “Judgments or other binding judicial adjudication, on account of damages for patent infringement, personal injuries, or other cause, are deductible from gross income when the claim is so adjudicated or paid, unless taken under other methods of accounting which clearly reflect the correct deduction, less any amount of such damages as may have been compensated for by insurance or otherwise….” BIR rulings also provide that damages paid under court-approved compromise agreement or out-of-court settlement is allowed as deduction.
It would seem that contractual penalties are deductible from gross income, as long as they are based on judgments or other binding judicial adjudication including court-approved compromise agreements. The earlier mentioned provision of the income-tax regulations also allow the deductibility of damages, paid to private persons, for violation of law, such as patent infringement, personal injuries and the like under the same ground. The only exception would be when the payments made are against public policy.
As far as the payment of damages without the intervention of the court is concerned, this matter is not clear. However, this can be considered as a deduction, provided that the general requisites for deductibility under prevailing rules are properly complied with. Moreover, the disallowance of such damages for wanting of fiat, runs counter to the policy of the state to actively promote party autonomy in the resolution of disputes or the freedom of the parties to make their own arrangements in resolving their disputes. To require a party to enforce its claim in the courts or through its assistance would deviate from the goal of settling disputes without litigation as a means of reducing clogged court dockets. Further, considering that these damages are taxable income on the part of the recipient; to make the equation equal, the same should also be considered as deductible on the part of the payor.
Notwithstanding the deductibility of the penalties incurred, taxpayers should be alarmed if the occurrence of penalties becomes common or customary. High frequency of penalties, regardless of its cause, is not only a tax risk but more of an organizational risk. Non-compliance, regardless of materiality, should be minimized if not eliminated.

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The author is a senior tax specialist of Du-Baladad and Associates Law Offices (BDB Law), a member-firm of World Tax Services (WTS) Alliance.
The article is for general information only and is not intended, nor should be construed as a substitute for tax, legal or financial advice on any specific matter. Applicability of this article to any actual or particular tax or legal issue should be supported therefore by a professional study or advice. If you have any comments or questions concerning the article, you may e-mail the author at reynaldo.prudenciado@bdblaw.com.ph or call 403-2001 local 380.