Companies must recognize earnest money damages as income on an accrual basis

The tax treatment of damages derived from the breach of earnest money contracts (contratos de arras) raises doubts regarding the exact moment they must be included in the taxable base of Corporate Income Tax (Impuesto sobre Sociedades). The Spanish Tax Agency's General Directorate of Taxes (DGT) has recently clarified the conditions for their recognition as income or expense.

What the DGT has ruled

The DGT establishes that received compensation constitutes accounting income when it increases the entity's net equity. From a tax perspective, this income accrues at the moment when the right to receive it is practically certain or secure.

A relevant aspect is the application of the cash basis provided for in Article 11.4 of the Corporate Income Tax Law (Ley del Impuesto sobre Sociedades). If the consideration for the indemnity is payable through successive payments and the period between the accrual and the final maturity exceeds one year, the entity may opt to attribute the income based on actual collection.

Conversely, when the company is the one required to pay the indemnity due to a breach, it is considered a deductible expense provided it meets the usual requirements: it must be recorded in the accounts, attributed on an accrual basis, duly justified, and not classified as a non-deductible tax expense.

What this means for you

For commercial entities, this criterion implies rigorous management of the timing for attributing income and expenses. Signing an indemnity agreement is not enough; it is necessary to evaluate the certainty of the right to determine the correct tax period.

Companies operating with contracts containing earnest money clauses must monitor whether payments are one-off or successive, as this will determine whether they can apply the cash basis to defer the tax burden until actual collection.

What should be done

It is necessary to analyze the structure of earnest money contracts and breach clauses to foresee the impact on Corporate Income Tax. Documentation justifying the certainty of the right to collection must be verified, and any indemnity expense must comply with accounting and tax regulations to ensure its deductibility.