Russian Federation: Development Of Court Practice On Tax Disputes Over Charging Personal Income Tax On Amounts Paid To Employees By Agreement At Termination Of Employment

On 16 June 2017 the RF Supreme Court rendered a ruling in case No. А42-7562/2015. In this case the court considered a dispute between Murmansk Trawl Fleet PJSC (hereinafter MTF) and the Federal Tax Service Interdistrict Inspectorate for Major Taxpayers in Murmansk Region. One of the subjects of the case was the charging of personal income tax on amounts paid to an employee by agreement between the employee and the employer at termination.

Earlier, in November 2016, we covered the decision of the Commercial Court of the Northwest District in this case. We recap the facts of the case here.

When dismissing employees MTF paid them large severance allowance amounts without withholding personal income tax from those amounts. The tax inspectorate disagreed with this approach and obligated MTF to withhold and remit personal income tax on those amounts to the budget.

The court of the first instance declared this part of the inspectorate's decision lawful. The appellate court disagreed with this position and resolved the personal income tax episode in the taxpayer's favor. The abovementioned Commercial Court of the Northwest District held that the position of the court of the first instance was well founded. However, the RF Supreme Court reversed that ruling regarding personal income tax, upholding the appellate court's ruling. In doing so the court relied on the following:

  • All types of compensation payments (within the limits set forth by the RF law) are exempt from personal income tax under Article 217(3) of the RF Tax Code.
  • Article 178 of the RF Labor Code provides for a number of specific cases of paying severance allowance and, at the same time, allows the right to stipulate other cases where this compensation is paid in the employment contract or collective agreement.
  • Contractual payment of severance allowance is a measure intended to protect the employee's rights, including those related to the termination of the employment relationship by agreement of the parties. At the same time, to protect the public interest when an employee is provided with such severance allowance, Article 217(3) of the RF Tax Code sets forth the limitation of the exemption of such income from personal income tax amounting to three times (or six times for certain cases) the monthly salary.

It can be said that the court's decision in this dispute has closed the chapter in disputes over the maximum severance allowance amounts that are exempt from personal income tax. It is noteworthy that when speaking of the three/six-time limit the RF Supreme Court expressly cited its own ruling in the MRSK Sibir case (Ruling No. 304-КГ16-12189). We remind readers that in that case severance allowance exempted from social security contributions was limited to the same amounts.

However, it should be borne in mind that the above approach was not used when resolving the issue of recognition of such severance allowance as expenses for corporate profits tax purposes. On 23 June 2017 a ruling of the Commercial Court of the Moscow District was rendered in the Parliament Production case (No. А40-94960/2015) (after the case was returned for reconsideration by the RF Supreme Court in September 2016). In that case the district court upheld the lower courts' decisions that expenses on payment of severance allowance by agreement of the parties were economically justified in the amount not exceeding two monthly salaries.

On the other side, in March 2017 in MHK Evrokhim case (No. А40-213762/2014) the RF Supreme Court upheld the taxpayer's right to deduct severance allowance in the amount from one-time to five-time monthly salary (Ruling No. 305-КГ16-18369).

The above disputes demonstrate that the courts' position on taxing severance allowance has stabilized as regards personal income tax and insurance contributions. However, the maximum amounts of such payments that are recognized as expenses for profits tax purposes may still raise questions. The lawyers of Dentons' Tax practice have considerable experience advising and litigating in this area and are ready to assist companies in both preparing proper documentation for payments to employees and in protecting their interests during the tax disputes.

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