BDB Laws Tax Law for Business appears in the opinion section of Business Mirror every Thursday.

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 wrongdoers 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 taxpayers 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.