Imagine the situation: a broken company car, destroyed goods in the warehouse, damaged machine by a supplier. It’s clear to everyone that it’s compensation – but what about VAT, what does accounting for compensation look like, what does income tax do with it, and how does accounting react?
The article explains what damages are from a legal perspective, what conditions must be met for a claim to be enforceable, and how damages and compensation are reflected in accounting as expenses and income. It shows the difference between a situation where compensation is paid by the wrongdoer and where it is received by the injured party, and how this results in the tax deductibility of costs and the taxation of income in different tax periods. Finally, we also look at compensation in the context of VAT.
The basis is always the same: damages are a loss of property – a diminution of the injured party’s property that would not have occurred but for the harmful event. It is regulated by the Civil Code (typically damage to property, loss of profit, damage caused by traffic, by an employee, etc.).
In order for you to have a legally enforceable claim for compensation at all, several conditions must be met:
Meeting these conditions is key to being able to effectively recover damages, for example from a supplier or an employee.
Get compensation for harm or damage – quickly and without stress. We will assess your chances, propose a strategy and prepare a challenge. All within 48 hours of placing your order. If necessary, we will then file a lawsuit and arrange legal representation. We will stand up for you fully.
Accounting regulations distinguish between:
Compensation for deficiency or damage is always taxable income and deficiency or damage is a tax expense only up to the amount of compensation, unless there are special exceptions (e.g. natural damage, damage caused by an unknown perpetrator documented by the police).
So the basic logic is: first we expense the damage, then we expense the compensation – and only the combination of the two will determine the impact of the whole event on the tax base.
In practice, it is not enough to know who should pay who and how much for the damage. Equally important is how the compensation will be reflected in your income tax – i.e. whether it is a tax deductible expense or taxable income.
From an accounting and tax perspective, whether you are in the position of the claimant who pays the damages or the victim who receives them, and the period in which the damages and compensation appear, is crucial. The following examples will show what the accounting for damages looks like in both situations and how it affects the tax base.
When you pay the damages as the damager, the Income Tax Act provides that the damages you are required to pay by law or by contract are a tax-effective expense. It is therefore an expense that you are legally obliged to incur and thus qualifies for tax deductibility.
Example: you break someone else’s machine that you lease and the lessor asks you to pay for the damage. If you pay by contract or by law, you charge the damage as an expense and treat it as tax-effective.
Find out what your employee’s liability is.
Conversely, when you receive compensation as the victim, it is taxable income for income tax purposes. Compensation paid to you by an insurance company, contractor, employee or other person enters your taxable income.
From an income tax perspective, the key is how the damage (or deficiency) in expenses and the compensation in income “meet” each other. In simple terms, shortfall or damage up to the amount of compensation received is a tax expense, while the part of the damage in excess of compensation received is usually a non-tax expense, unless there are special cases such as a natural disaster or damage caused by an unknown perpetrator documented by a police report. The ideal situation arises when both the damage and the compensation occur in the same tax year, in which case their impact on the tax base is usually automatically offset within the same year.
A more complicated situation is when you book the damage in one year and the compensation arrives in the following year. In this case, it is no longer enough to leave everything on the books, but it is necessary to work with items that increase and decrease the tax base in the tax return. The part of the compensation that covers the damage that was a tax-deductible expense in the previous year is shown in the following year as an item reducing the tax base, and only the excess of the compensation over the damage so covered is actually taxed.
The VAT Act itself does not contain the word ‘damages’ at all – and this is no coincidence. In fact, the settlement of damages is not subject to VAT because it does not constitute a supply of goods or services. Therefore, compensation for damages is not included in the VAT return at all.
In practice, this means that you will invoice for the damages without VAT. You can explicitly state “Damages – not subject to VAT” on the invoice to make it clear why you are not charging tax.
Beware that not every transaction that the parties call “compensation for damages” is a genuine compensation for VAT purposes. The economic substance – whether the payment is not in fact consideration for the supply of goods or services– is decisive.
There is a special situation in which compensation becomes subject to VAT. However, two conditions must be met:
Typically, the theft of goods is not itself a supply of goods for consideration and is not itself subject to VAT unless the damage is compensated in some way. However, if you agree with the offender (or another person) to pay compensation and at the same time obtain the right to dispose of the goods as owner, this situation may effectively constitute a supply of goods for consideration – in which case VAT is already an issue.
Similarly, if the “compensation” actually covers a service provided (for example, a fee for early termination of a contract that is linked to enabling some performance), it is a supply of a service for consideration and therefore a taxable supply.
However, for most common damages (broken goods, damaged property, compensation from an employee, compensation charged to a transport company) a simple rule applies: compensation is not subject to VAT and is invoiced tax-free.
Damages in accounting and tax always stand on two pillars: the damage itself (shortfall) and the compensation. Damage is a loss to property and is usually charged as an expense in the accounts (Group 54), while compensation is income (Group 64) and always enters the tax base. When you, as the damager, pay the damages, it is usually a tax deductible expense if it arises from law or contract. Conversely, when you receive the compensation, it is taxable income. From an income tax point of view, the key is whether the damage and the compensation appear in the same tax year – if not, it is necessary to work with items increasing and decreasing the tax base in the tax return so that the logic of “damage covered by compensation is taxable, surplus is non-taxable” is correctly reflected.
As far as VAT is concerned, typical compensation for damages is not subject to VAT because it is not a supply of goods or services. The invoice for compensation is therefore issued without VAT. However, care should be taken in situations where the term ‘compensation’ actually refers to payment for the supply of goods or services – for example, where the offender becomes the owner of the stolen goods in return for payment or where the payment is effectively a contractual fee for a service. In these exceptional cases, the supply may already be subject to VAT.
From an accounting point of view, it is always the same compensation. The difference is mainly in the documentation and the limits that employees have under the Labour Code. From an income tax point of view, in all these cases it is typically taxable income if the damage relates to business assets.
For tax accounting (income and expenses), the principle is the same as in accounting: compensation received for damages relating to business assets is taxable income; damage (deficiency) is a tax deductible expense up to the amount of compensation received; and damage in excess of compensation is generally a non-tax expense.
The insurance benefit received from the insurance company is not a consideration for your taxable benefit, but the realisation of the insurance contract. From a VAT point of view, it is not a taxable supply for which you should declare output VAT.
Economically, both are compensation for damages, but legally, the compensation is a claim against the wrongdoer (contractor, employee, third party) and the insurance claim is the benefit you receive from the insurance company. In accounting, both typically show up as income, but in tax law, insurance benefits have special rules – for example, for individuals, some benefits may be tax-free, others taxed.
Get compensation for harm or damage – quickly and without stress. We will assess your chances, propose a strategy and prepare a challenge. All within 48 hours of placing your order. If necessary, we will then file a lawsuit and arrange legal representation. We will stand up for you fully.
Ondřej is the attorney who came up with the idea of providing legal services online. He's been earning his living through legal services for more than 10 years. He especially likes to help clients who may have given up hope in solving their legal issues at work, for example with real estate transfers or copyright licenses.
In person and online. Just choose the appropriate service or opt for an independent consultation when you are unsure.
