A contractual penalty is a punishment… Or is it already a service?

Understanding VAT on Contractual Penalties: The classification of a payment as a “penalty” in civil law does not determine its VAT liability. The Court of Justice of the European Union (CJEU) emphasizes the importance of the economic reality, focusing on whether there is a direct relationship between the payment and the provision of goods or services.
When VAT is Applicable: Payments labeled as penalties may still be subject to VAT if they serve as compensation for services provided. For instance, control fees for improper parking are seen as part of the overall price for the parking service. Similarly, penalties for early contract termination can be viewed as payments for the right to withdraw from a service or agreement.
Exemptions from VAT: Not all penalties incur VAT; those that strictly aim to prevent undesirable behavior without providing a measurable benefit, or payments that solely compensate for damages without service provision, are exempt. The distinction hinges on whether the payment is for a service or merely for restitution of losses, requiring careful analysis of the transaction’s nature.