Development of the court practice on accrual of personal income tax on payments to employees associated with termination of the labor contract by mutual agreement

Over the last few years, the subject of taxation of payments to employees when terminating employment contracts has led to a large number of disputes between taxpayers and the tax authorities. This September, the RF Supreme Court considered the case of Parliament Production, where the Court effectively recognized the right of the tax authorities to verify the economic justification of payments organizations make to employees when terminating their employment contracts and the recognition of organizations’ expenses on such payments for profit tax purposes (Ruling of 23.09.2016 № 305-КГ16-5939 case № А40-94960/2015). At the same time, the court noted that the tax authorities may conduct such verification with respect to payments made after 1 January 2015, the effective date of the new revision of clause 9 of article 255 of the Russian Tax Code, which under a literal reading allows taxpayers to recognize payments (accruals) to dismissed employees stipluated by, among other things, agreements for termination of employment contracts. As a result of hearing by the Court, the dispute was returned to the court of first instance (Moscow Arbitration Court) for retrial, where it has been scheduled for hearing on 28 November 2016.
This subject was further developed in the Ruling of Northwestern District Arbitration Court of 27.10.2016 № А42-7562/2015 in the Murmansky Trawler Fleet case.
This dispute among other things concerned personal income tax (PIT) on amounts paid to an employee under an agreement between the employer and employee for termination of the labor relations. Before consideration of this case, there were essentially no judicial disputes on this matter, the right of individuals to exemption of the corresponding payments from PIT was not questioned in judicial practice.
The facts of the case were that the organization dismissing employees paid them “severance benefit” without withholding PIT. The taxpayer based its position on clause 3 of article 217 of the Russian Tax Code, according to which payments in connection with the dismissal of employees are not subject to income tax. The tax authority disagreed with this approach and imposed an obligation on the organization to withhold and transfer income tax on the said payments to the budget.
In the end, the tax authority was supported by the court of cassation instance, which stated as follows:

  • The relations between the employees and employer were terminated on the basis of clause 1 of article 77 RF TC, i.e., by mutual agreement of the parties;
  • The severance payments were not provided for in MTF bylaws, but were established by separate agreements concluded right before the dismissals;
  • Compensatory payments related to dismissal are not subject to income tax only if they are established by applicable RF law;
  • In this case, the disputed payments are not severance benefits provided by the Russian Labor Code. Therefore, they are not tax exempt on the basis of clause 3 of article 217 of the Russian Tax Code.

The cassation instance court ruling means that certain trends can be observed in the development of the law-enforcement practice on the taxation of payments made to the dismissed employees. In this sense it should be viewed not only in the context of personal income tax disputes, but keeping in mind other taxes and mandatory payments accrued in similar situations as well.
Thus the attention should be drawn to the fact that in December this year the Judicial Panel for Economic Disputes of the RF Supreme Court will also hear the dispute of MRSK Sibir (case № A46-7158/2015) on whether “severance benefits” are subject to insurance contributions to state extrabudgetary funds, which the taxpayer lost at the cassation instance.
These examples from the court practice demonstrate that taxation issues related to payments to employees, especially at the termination of employment relations, may cause significant difficulties. Dentons Tax practice specialists have extensive experience of consulting and litigation in this area and are ready to provide any related assistance the companies need, both in drafting the proper supporting paperwork underlying such payments to employees, and in defending their position during the tax disputes.

Dzhangar Dzhalchinov

About Dzhangar Dzhalchinov