A contractual penalty provides the creditor with the assurance that the debtor will be more motivated to fulfil the obligations imposed by the contract. It is easy to negotiate and apply. Nevertheless, it may not always be advantageous to the creditor. Some of its specifics, such as the relationship to damages, limits on the amount of damages, or the statute of limitations, may also raise questions. This is what we have focused on in our article.
A liquidated damages is a possible (but not mandatory) part of a contract in which one of the parties to the contract agrees to perform a certain amount (usually paying a certain amount) if it breaches one of its contractual obligations (for example, to deliver some goods within a given period of time).
What is relevant for the application of liquidated damages is the breach of the contractual obligation itself and not whether the other party has suffered any damage as a result. Even if the damage is less than the amount of the contractual penalty, or even none at all, the contractual penalty must still be paid (for example, if the deadline for delivery of the goods is not met, the debtor will be forced to pay the contractual penalty even if this fact does not restrict the other party’s business or other activities).
The debtor will also normally (unless otherwise agreed) have to pay the liquidated damages regardless of its fault. Thus, for example, if the van with the goods did not arrive because it was hit by a stranger or because a tree fell on it and destroyed the cargo.
If the amount is set correctly, securing a contract with a contractual penalty can be much more beneficial and easier than claiming damages.
Unlike liquidated damages, which refer to actual damages, liquidated damages do not require proof of the amount of damages. Thus, in practice, there may be situations where the parties to a contract are faced with the question of whether the liquidated damages are subject to VAT, similar to the VAT on damages.
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In this context, it is important to point out that by agreeing a contractual penalty , the creditor loses the right to compensation for damages arising from the breach of the obligation to which the contractual penalty relates. The contractual penalty thus plays the role of a ‘ lump sum’ compensation under the Civil Code. If you have, for example, agreed in your contract that the manufacturer is obliged to pay a contractual penalty of CZK 100,000 in the event of a machine failure, you cannot claim damages of CZK 200,000 even if you prove it to the last penny. A person ignorant of this fact can easily be fooled into thinking that the contractual penalty (even if agreed at a very low level) is a nice “insurance” of the contract and a kind of possible extra bonus, but in reality he may lose a much larger sum.
On the other hand, however, the law does not prevent the parties from agreeing that the contractual penalty does not affect the creditor’s right to claim compensation for damages arising from the breach of the contractual obligation to which the penalty, whether monetary or non-monetary, relates. Such a procedure is certainly more pragmatic and can be recommended.
Unless the parties’ contractual agreement on liquidated damages provides otherwise, the payment of liquidated damages does not relieve the debtor of the obligation to fulfil the original obligation.
As mentioned above, the most common form is an obligation to pay a lump sum (e.g. a lump sum of money). However, it may also be a specific amount (percentage or fixed) for each day of delay in performance. A contract usually provides for several obligations, the breach of which is not always of the same severity. In such a case, it is proposed to negotiate an upper limit for the contractual penalty and to graduate the specific amount depending on the criteria set.
In addition, the contractual penalty does not have to take the form of a monetary amount only: it can also be the performance of work, the transfer of some things, etc. E.g. if I don’t deliver 100 tonnes of coal by a certain date, I will deliver a tonne more for every week day late.
The definition of the obligation to which the penalty is attached is very important. It is possible to specify only certain obligations under the contract, the performance of which is secured by the penalty, or the penalty can be linked to the breach of ‘any’ obligation under the contract. The Supreme Court was previously reluctant to adopt such a formulation, but in a later decision it also accepted this option. In any event, for the legal certainty of both parties , it is better to formulate the breach of obligations very precisely – either by reference to the provision of the contract in which they are found, or by reiterating the obligation.
The reasonableness of the contractual penalty is also a major issue. The amount of the contractual penalty is not limited in advance by law. A contractual penalty of 0,50 % per day of the amount due for each day of delay is sometimes referred to as a disputed limit. This has already been assessed as excessive by some courts. Others, however, have allowed even 1% of the amount due per day. Obviously, the situation would be assessed on a case-by-case basis and the reasonableness or unreasonableness of the contractual penalty cannot be prejudged. The reasons and circumstances which led to the negotiation of the amount of the contractual penalty under consideration are always relevant.
If the court finds the contractual penalty to be excessive, it may decide to reduce it to a ‘reasonable’ amount if necessary. However, this is only ever done at the debtor’s request, which is to the advantage of the creditor, who can thus achieve the reasonableness of the contractual penalty.
If the amount of the penalty payment is manifestly unfair, it would be an invalid agreement under the Civil Code.
A liquidated damages clause may be included in the terms and conditions of business if two entrepreneurs refer to it. However, if the contract with the entrepreneur is concluded by a consumer, it can only be agreed in the contract itself, not by reference to the terms and conditions. In such a case, the negotiation would be regarded as absolutely null and void.
Make sure that the contractual penalty is related to the context of the whole contract and forms a whole with it. Searching for models on the internet is not usually helpful in this respect. A contractual penalty does not have a pattern that fits every situation. On the other hand, for the layman, it is advisable to consult a lawyer, as an incorrectly negotiated contractual penalty can lead to its invalidity.
Importantly, you can also negotiate a contractual penalty orally. The conventional idea that a written contract is required no longer applies. However, you must of course take into account the conclusiveness of such an agreement. This can be based on an e-mail conversation or the testimony of a trustworthy witness.
The tax implications of contractual penalties must also be taken into account when dealing with them. In some cases, the question may be whether a contractual penalty or damages are subject to VAT. According to recent case law, it depends on the specific nature of the transaction – if a contractual penalty replaces the price of the transaction, it may in certain cases be seen as a transaction for consideration subject to VAT.
It is important to bear in mind that while a contractual penalty is primarily punitive in nature and is generally not subject to VAT, the situation may be more complex with regard to compensation for damages. In practice, we encounter cases where the tax authorities examine whether it is compensation for lost income or actual compensation for damages that would not be subject to VAT.
Tip: A contractual penalty is charged for breach of the relevant contract. It is not a payment for the supply of goods or services and is therefore not subject to value added tax (VAT).
The law does not explicitly state when a contractual penalty is due. It is therefore worthwhile to expressly stipulate its due date in the contract. This can be done by a specific time limit (the day of default or, for example, seven days after default) or by linking the due date to a written notice from the creditor. The limitation period for contractual penaltiesruns independently of the original contract and is three years from the date on which the contractual penalty is due.
However, if the debtor fails to pay the contractual penalty even after it has become due, default interest shall be added to it. This situation is distinguished from the negotiation of conventional contractual default interest, which may be negotiated in addition to the contractual penalty, as the two are not mutually exclusive.
Previously, the law did not allow the negotiation of a contractual penalty in a lease agreement. However, the amendment effective from July 2020 has removed this obstacle. As the tenant is generally in a weaker position in this contractual relationship, he is protected by the law in this respect, so that the contractual penalty together with security cannot exceed three times the monthly rent. At the same time, the Civil Code states that unreasonable obligations cannot be imposed on the tenant and therefore an unreasonable contractual penalty cannot be demanded.
Securing the lease by a combination of security and liquidated damages can also bring positive benefits for the tenant. Although visually the amount remains the same (i.e. a maximum of three times the rent), the penalty will not be payable before the commencement of the tenancy but only in the event of a breach of duty. In effect, therefore, the upfront amount may be significantly reduced, which may make housing slightly more affordable again. However, the landlord is left with the same level of security. The downside, however, can of course be the subsequent enforcement of the penalty, which may not be straightforward.
Tip: Did you lend your neighbour money and somehow he is reluctant to pay it back? What deadlines do you have to watch out for so that your claim is not time-barred? Is there any way to recover a time-barred debt, and does returning a time-barred debt constitute unjust enrichment? And what about the limitation of other rights? We will look at all this in a separate article.
As we have mentioned several times, the contractual penalty should be related to the breach of the obligation, so it cannot be used to sanction the withdrawal from the contract, since in such a case it is the exercise of a right, not a breach. The court may consider such an arrangement as severance pay instead of a contractual penalty, which is governed by different rules. According to previous case-law, “where a contractual penalty is essentially a penalty for the exercise of the right to withdraw from the contract, an agreement on the obligation to pay a contractual penalty on withdrawal must be regarded as absolutely void.”
A contractual penalty is a contractual instrument which motivates the debtor to perform its obligations and provides security to the creditor. Unlike damages, it does not require proof of injury and is payable irrespective of fault. However, unless otherwise agreed, liquidated damages replace the right to compensation, which may be disadvantageous for the creditor. The amount of the penalty is not limited by law, but the court may reduce it on the debtor’s application if it is excessive. The contractual penalty may be agreed orally, its due date should be specified in the contract and, if not paid on time, it is subject to default interest. In lease agreements, the maximum amount is limited to three times the monthly rent. When negotiating it, it is important to ensure legal precision and consider its tax implications, including possible VAT liability.
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