In Mexican tax law, the classification and legal nature of payments arising from penalties, liquidated damages, and compensation for damages are crucial to determine their correct tax treatment. These figures frequently appear in contracts, court rulings, and administrative procedures. Misinterpreting their legal nature can result in unintended tax consequences, ranging from the disallowance of deductions to the incorrect application of VAT. This article examines the conceptual distinctions among these figures and analyzes their implications for corporate taxpayers, particularly in terms of Income Tax (ISR) and Value-Added Tax (VAT).

I. Introduction

The legal and tax treatment of punitive or compensatory payments is a recurring topic in Mexican tax practice, especially in litigation, compliance, and transactional contexts. The failure to properly identify the nature of a payment, whether it is punitive, contractual, or restorative, can lead to substantial financial repercussions for taxpayers. Moreover, legal practitioners and advisers must be aware of the different criteria that tax authorities and courts may apply in evaluating these payments.

This article seeks to clarify the applicable tax treatment under Mexican law for three distinct legal concepts: penalties (sanciones), liquidated damages (penas convencionales), and compensation for damages (indemnización por daños y perjuicios). Each figure entails unique legal effects and fiscal consequences that must be assessed on a case-by-case basis, considering the contract language, legal classification, and factual context.

II. Penalties

Penalties are unilateral, coercive, and punitive acts imposed by the state under its sovereign power (ius puniendi). These sanctions are triggered by the breach of a legal norm and must be imposed by a competent authority in accordance with the principles of legality, typicity, and proportionality.

Such penalties are found in administrative and criminal contexts and aim to reestablish public order and deter unlawful behavior. In tax matters, common examples include fines imposed by the Tax Administration Service (SAT) for late filings or omissions.

From a tax perspective, penalties are not deductible for ISR purposes under Article 28 of the Mexican Income Tax Law, which expressly excludes them. Furthermore, they are not considered a supply of goods or services and thus do not generate VAT. These payments result in an economic impact on the CUFIN (Net Tax Profit Account) or UFIN (Net Taxable Profit) by reducing them by 30%. This effect is particularly relevant in group companies or when determining dividend distribution capacity.

III. Liquidated Damages (Penas Convencionales)

Liquidated damages are contractual obligations established bilaterally to address breach, delay, or defective performance of a principal obligation. These clauses aim to compensate and liquidate damages, without requiring proof of actual harm or causation. They are commonly included in commercial contracts, including construction, supply, and service agreements.

The deductibility of liquidated damages for ISR purposes depends on their legal nature and origin. If attributable to the taxpayer’s fault and duly documented, such payments may be deductible under certain interpretations and must be carefully evaluated. Otherwise, they are non-deductible and reduce the CUFIN/UFIN accordingly.

Regarding VAT, liquidated damages are considered part of the consideration for taxable acts, such as the provision of services or leasing of goods, when expressly provided in a contract. The Federal Tax Court has supported the view that such damages can be treated as consideration, thus making them subject to VAT. In these cases, VAT must be included in the invoice (CFDI) and paid accordingly. However, the VAT paid may only be creditable if the liquidated damages are also deductible, requiring a coordinated approach between accounting and legal teams.

IV. Compensation for Damages

Compensation for damages arises from either contractual or extra-contractual liability and is intended to restore the injured party’s patrimonial situation. It may be judicially or administratively ordered and generally includes both direct losses (daño) and lost profits (perjuicio). These payments are rooted in the principle of full reparation and are often imposed following a final judgment.

Such compensation is typically non-deductible for ISR purposes, unless derived from business-related risks and documented within the framework of a legal obligation. If paid in foreign currency, exchange gains or losses must also be considered for tax purposes, especially in multinational contexts.

For VAT purposes, compensation for damages does not give rise to a taxable event, as it does not constitute consideration for a good or service. Therefore, no VAT is triggered. The SAT has issued criteria confirming that these payments do not form part of a taxable base, reinforcing the importance of correctly characterizing them in contractual and procedural documents.

V. Case Analysis

Some common scenarios illustrate the complexity of these distinctions:

- Penalty clauses in lease contracts, triggered by early termination by the tenant, are considered liquidated damages. If tied to a taxable act, they trigger VAT and may be deductible depending on their legal nature.

- Compensation due to fiduciary liability or damage to neighboring property is treated as indemnification and does not generate VAT. These payments are generally non-deductible but may require the payer to withhold taxes if paid to individuals.

- In settlement agreements, if the parties agree to perform or refrain from performing certain acts, this may constitute a taxable service, thus triggering VAT. It is essential to review the language and structure of such agreements to determine if a supply is being made.

Ultimately, each case must be carefully analyzed to determine the underlying legal figure and apply the corresponding fiscal treatment. Coordination between litigation and tax teams is vital to ensure consistency in legal argumentation and compliance with tax obligations.

VI. Conclusions

The distinctions among penalties, liquidated damages, and compensation for damages are not merely theoretical, they have direct and significant fiscal consequences. The key takeaways include:

- Penalties are never deductible and do not generate VAT.
- Liquidated damages may be deductible and trigger VAT if tied to a taxable contract.
- Compensation for damages may be deductible in specific scenarios but never gives rise to VAT.

The fiscal impact of these payments extends beyond immediate tax liabilities. They also affect long-term planning, financial reporting, and compliance strategies. Companies should develop internal protocols for classifying and documenting such payments, particularly in the context of contractual negotiations and dispute resolution.

Given the complexity and the potential tax exposure, taxpayers are advised to consult with specialized counsel when dealing with such payments. At Von Wobeser y Sierra, we recommend conducting a thorough legal and factual analysis for each case, in coordination with litigation and tax teams. Legal precision and fiscal prudence are essential to mitigate risks and ensure alignment with both contractual and regulatory frameworks.