While signing a settlement with an employee, the employer should take care of the appropriate wording of the settlement, sign it before the court and apply for a tax ruling.
The new year has brought many changes in the tax acts. One of them is an amendment to article 21 section 1 point 3 of the PIT Act, which has extended a catalogue of sources of labour law enabling the payment of PIT exempt damages or compensation. According to the new wording of this regulation, the damages or compensation received are tax exempt if their amounts or the rules of determination arise straight from the provisions of separate acts (e.g. the Labour Code) or secondary regulations issued on the basis of these acts. Also, received damages or compensation are tax exempt if their amounts or the rules of determination arise straight from the provisions of collective bargaining agreements, other collective arrangements, rules and regulations or statutes referred to in article 9§1 of the Labour Code which are based on the act.
In practical terms, an interpretation of this regulation is conclusive for the employer to decide whether to deduct or not to deduct the tax on the amount paid the employee as damages or compensation. The concern with an appropriate application of the regulation at issue arises in the event of damages paid under settlements concluded with the employees when the employment relationship was terminated not in compliance with law.
Damages paid on the basis of the settlement are also the income
Pursuant to the PIT Act, the income from the employment relationship includes any type of payments and allowances resulting in a financial benefit of the tax payer and arising out of the relationship between the employee and the employer or any related relationship. Such income is therefore also an amount of money arising out of the signed settlement.
Settlement other than the court settlement is subject to PIT
According to the rule of article 21 section 1 point 3 of the PIT Act, damages and compensations arising out of the executed agreements and settlements other than those concluded before the court shall be always taxable. It is therefore beyond doubt that income tax will be imposed on the damages resulting from a settlement other than the court settlement. Thus, from this perspective the execution of an out-of-court settlement is disadvantageous.
Settlement concluded before the court
A question thus arises if, in the event of a settlement concluded before the court, the damages or compensation which are paid will be tax exempt or the employer (or the ex-employer), while paying the agreed amount, must deduct a respective tax advance. An answer does not arise directly from the provisions of law, what is more, the fiscal authorities themselves present in this respect various opinions.
Some fiscal authorities are of the opinion that article 21 section 1 point 3 of the PIT Act cannot be applied in this situation since the damages or compensation do not arise straight from the labour law provisions but from the arrangements made between the parties to the settlement, therefore such damages or compensation are of a purely contractual nature. This stance was also presented by the Supreme Administrative Court in its recently issued ruling (dated 21 January 2015, file no. II FSK 2918/12).
Alternatively, in such a situation, article 21 section 1 point 3b of the PIT Act may be sought to be applied and serve as the legal basis for the tax exemption of the compensation paid. Pursuant to the above mentioned article, other damages or compensations received as a result of a court ruling or settlement are PIT exempt up to the amount stipulated in such ruling or settlement, except for the damages or compensations received in connection with the conducted business activity or relating to the benefits that the taxpayer could have attained if it had not suffered the damage.
The point is that certain tax authorities maintain that the damages paid to the employee for illegal termination of his/her employment contract are supposed to compensate for his/her lost (as a result of the employment contract termination) and expected benefits in the form of remuneration for work that he/she would have received if the damage had not occurred and they do not adjudge the exemption.
Divergent tax interpretations
For example, in the tax ruling dated 4 April 2014 (file no. IPTPB1/415-706/13-2/DS.) the Head of the Fiscal Chamber in Łódź decided that the consideration stipulated in the settlement granted to the employee for the damage in the form of termination of his/her contract, is not exempt from tax either on the basis of article 21 sec. 1 point 3 or article 21 section 1 point 3b) of the PIT Act. In the opinion of the fiscal authority “the amount of or rules of determination of the consideration in question do not straightforwardly result from the provisions of separate acts or secondary legislation. Moreover, such damages represent a compensation for the expected benefits in the form of remuneration for work which have been lost by the employee as a result of the agreement termination”. A similar position was presented by the Head of the Fiscal Chamber in Bydgoszcz in tax ruling dated 19 August 2014 (file no. ITPB1/415-607/14/AD).
In another interpretation however issued on 10 August 2014 (file no. ITPB2/415-282/14/IB) the Head of the same Fiscal Chamber in Bydgoszcz stated that received damages for illegal termination of the agreement enjoys tax exemption.
As presented above, in similar cases the stance of the same fiscal authority extremely differs. Therefore, while entering into the settlement with an employee it is worth taking care of its appropriate wording, concluding it before the court and, possibly, applying for a tax ruling to protect the employer as the tax withholding agent.