Contractual penalty

What it means

A contractual penalty is an agreed sanction for breaching a contractual duty. It is payable whether or not loss arose and regardless of its size, which is its main attraction for a creditor.

It must be agreed in writing and definitely: for which breach, how much and how it is calculated. A disproportionate penalty will be reduced by a court on application.

A penalty secures a specific duty, and paying it does not release the debtor from that duty. A contractor who delivers late pays the penalty and must still finish the work, unless the parties agree otherwise. This follows from the Civil Code and is the main difference from a withdrawal fee, with which a party buys its way out of the contract.

How it works in practice

Contracts tie it to deadlines and quality: late delivery, missed SLA, breach of confidentiality. On works contracts it is usually a percentage of the price per day with a cap.

Late payment interest can run alongside it where the contract says so clearly. The right to claim damages beyond the penalty must also be expressly preserved.

In the books a penalty received is revenue and a penalty paid is a cost. Contractual penalties enter the tax base only once paid, for both creditor and debtor, so a penalty invoiced but not yet settled does not affect tax yet. At the year end we therefore track them separately and adjust the result for them.

What to watch out for

A penalty with no cap grows disproportionate over a long delay and a court will cut it. A moderate capped penalty serves a creditor better than a high one that will not survive a dispute.

A penalty must be claimed promptly and provably. A creditor who tolerates delays for years without invoicing the penalty risks limitation and, in a dispute, the argument that the delay was tacitly accepted. Sending a demand soon after the breach is sensible, even while the relationship continues.