In May 2020, we informed you about a ground-breaking decision of the Supreme Administrative Court which rejected the practices of the Tax Administration consisting in the necessity of “additional taxation” of the sanction receivables amount upon their assignment. In its new decision, the Supreme Administrative Court follows up on the previous decision and comments in detail on the rules applied in the determination of the income tax base when such receivables are assigned.
Assignment of receivables arising from contractual sanctions
The Income Taxes Act includes different regime for the taxation of receivables arising from standard business transactions and receivables arising from contractual sanctions. Income recognised in relation to a contractual sanction is subject to taxation only at the moment when the entity actually receives the funds. The difference in the taxation method also depends on the moment when receivables are assigned; if a sanction receivable ceases to exist in another way than by fulfilment, the tax assessment is different from a standard receivable. For the sake of clarification, we add that it is possible to recognise statutory provisions for standard receivables which in the end reduce the non-deductible loss from assignment. In the case of sanction receivables, however, the recognition of statutory provisions is expressly excluded by law.
In addition, the regime of taxation of assigned receivables arising from contractual sanctions (i.e. arising from a contractual fine, interest and default fees, penalty etc.) depends on whether the receivable arose and was assigned in the same taxation period, or whether it arose in the period preceding its assignment.
The regime of taxation of the first case, i.e. case of receivables arising from contractual sanctions that were recognised in income in the same taxation period in which they were assigned, does not give rise to any further doubts as it is explicitly defined by the legislature as follows: the profit or loss is not adjusted specially according to the rules for sanction receivables.
In its recent decision, the Supreme Administrative Court commented the second situation,
i.e. the issue of determining the income tax base in the event of assignment of receivables arising from contractual sanctions that were items reducing the profit in preceding taxation periods, i.e. a situation where a receivable is assigned in a period following its arising. In other words, it is a situation where it was recognised in income in the taxation period in which the receivable arised, but the due amount was not fulfilled by the debtor and therefore the profit is reduced by this amount under Section 23 (3 b) 1) of the Income Taxes Act (the outstanding receivable arising from contractual sanctions is not subject of taxation). And it is assigned only in the following period.
It is easiest to imagine such a situation with an example taken over also by the Supreme Administrative Court, where the assignor assigns a receivable arising from contractual penalties in the balance sheet amount of CZK 100,000 for consideration of CZK 1,000. The loss from the assignment in such a case will amount to CZK 99,000 and the assignor will increase the profit by this amount as a tax non-deductible expense which is, under certain conditions, a rule generally applicable to any receivable.
The subject matter of the dispute before the Supreme Administrative Court was the issue whether the profit should subsequently be increased by the total balance sheet amount of the assigned receivable (CZK 100,000 in our case) as that is the value of the receivable that has not been taxed thanks to the special tax treatment, or whether it will be increased only by the actual proceeds from the assignment (CZK 1,000 in our case).
Practice applied by the Tax Administration
The Tax Administration believed in respect of the above example that the assignor should increase the profit by the entire balance sheet value of the receivable (CZK 100,000) in such a situation. Section 23 (3, a), 6) of the Income Taxes Act relieves the taxpayer from the additional taxation of the sanction receivable amount (i.e. amount that has not been taxed yet due to the absence of the actual fulfilment), however, only provided that the profit was increased by the same amount (i.e. the balance sheet amount of the receivable amounting to CZK 100,000) due to a tax non-deductible expense. Our situation does not meet this condition according to the Tax Administration, as the tax non-deductible loss from the sale of the receivable was only CZK 99,000.
The interpretation of the relevant provisions by the Tax Administration ultimately resulted in a situation where the assignor in the above example would be obliged to increase the profit by CZK 199,000, i.e. an amount exceeding the nominal value of the receivable itself, in the year of assignment.
Interpretation of the Supreme Administration Court
The Supreme Administrative Court maintained its opinion that the Income Taxes Act favours actual income to recognised income, i.e. the cash principle, in respect of sanction receivables. In the taxation of receivables arising from contractual sanctions, it is therefore necessary to bear in mind the fact that their fulfilment is highly uncertain, and they should be taxed when fulfilled, if they are fulfilled at all.
In view of the above, the Supreme Administrative Court confirmed that the increase in the profit under Section 23 (3 a) 6) of the Income Taxes Act is excluded in the scope in which the profit was already increased under item 2 of the same paragraph, i.e. due to the tax
non-deductible loss from assignment. In such a case, the assignor is obliged to increase the profit only by the amount corresponding to the proceeds from the assignment of receivables (CZK 1,000) which, together with the tax non-deductible loss arising from assignment (CZK 99,000), equals the balance sheet value of the receivable (CZK 100,000).
As a result, the Supreme Administrative Court assessed the current approach of the Tax Administration to this matter as incorrect. If you assigned a sanction receivable in past years, it is advisable to verify the way of its taxation and consider the possibility of filing an additional tax return.