Tax Implications in Employee Claims and Settlement Agreements
When is compensation paid to an employee taxable? As a general rule, when a payment replaces taxable income, the compensation is also taxable. The rule is that “the tax treatment of the compensation follows the nature of the loss it is intended to replace.” Therefore, a payment for unpaid salary, salary differentials, a bonus, or accrued vacation pay will generally be taxable as employment income, even if paid following a claim or as part of a settlement. The mere use of the word “compensation” does not create a tax exemption.
When may an exemption apply? A distinction should be made between an exemption expressly provided by law and a payment that is not taxable income in the first place. For example, severance pay or a retirement grant may be exempt up to the applicable ceiling and subject to the conditions set out in Section 9(7A) of the Income Tax Ordinance. Any amount exceeding the exemption will generally be taxable. Section 9(7) provides an exemption for a capital sum received as comprehensive compensation for death or bodily injury, but this does not mean that every payment for emotional distress is exempt. Compensation for an independent personal injury, such as harm to dignity or reputation, may not be considered taxable income if it does not replace salary or other income and does not arise from a taxable source of income. Even where the compensation is paid in respect of discrimination or sexual harassment, each component must be examined according to what it is intended to compensate: loss of salary, as opposed to personal harm. The label “non-pecuniary damage” alone is not sufficient to negate tax liability.
How is this distinction applied in a claim or settlement?
The salary and monetary entitlement components should be separated from the personal injury components, and the factual basis and method used to determine the amount of each component should be documented. For example, in a settlement that includes salary differentials and compensation for harm to reputation, the salary differentials will generally be taxable. With respect to harm to reputation, it must be substantiated that the payment genuinely compensates for personal injury and is not a disguised salary payment. The Israel Tax Authority may examine the allocation even if the agreement has been approved as a judgment. It is therefore advisable to review the classification and withholding tax obligations before signing, in order to assess the net amount that will remain with the employee.
This issue was discussed, among other cases, in Tax Appeal 53681-12-16 Shahaf v. Gush Dan Assessing Officer. The judgment emphasizes that, for tax classification purposes, the substance of the payment and the damage it is intended to compensate must be examined, rather than relying solely on the label attributed to it in a settlement agreement or judgment.
In Tax Appeal 1146/03 Davidovitz v. Netanya Assessing Officer, the court also emphasized that it is necessary to examine whether the compensation is intended to compensate for damage that does not arise from a source of income taxable under Israeli tax law, or whether it effectively replaces income or rights arising from the employment relationship.
The judgment in Erez Ben Enosh v. Ramla Assessing Officer, Tax Appeal 63585-11-17, delivered by the District Court, further clarifies that a settlement agreement, even if approved as a judgment, does not bind the Israel Tax Authority with respect to the tax classification of the payment. The court dismissed the appeal and held that the Israel Tax Authority is entitled to examine the true economic substance of the payment, and not only the classification and labels set out in the settlement agreement. The court noted that the emotional distress component was unusually high compared with the amounts typically awarded for non-pecuniary damage. Allocating an unusually high amount to this component, without sufficient support in the facts, evidence, and nature of the cause of action, may create difficulties both from a civil law perspective and from a tax perspective.
As reflected in the case law, the mere fact that compensation is awarded in an employment claim or paid under a settlement agreement does not determine the tax treatment. The tax question is examined separately, based on the substance of the payment and the circumstances of the case. It is necessary to examine what the payment is intended to cover: whether it replaces salary or an employment right, or whether it compensates for another type of personal injury. The evidence and the way in which the compensation components were presented in the statement of claim, affidavits, judgment, and settlement agreement are also examined. Therefore, the label given to a compensation component is not sufficient in itself and does not guarantee a tax exemption.
The practical conclusion is that detailing the compensation components in the agreement is not sufficient in itself. The allocation between the components must be genuine, reasonable, and consistent with the statement of claim, the facts, the evidence, and the economic substance of the payment.
A settlement agreement should specify the payment components clearly, accurately, and consistently with the statement of claim, the facts, and the evidence. Interest, linkage differentials, legal fees, and reimbursement of expenses should also be examined separately.
The tax aspects of employment claims and settlement agreements may have a direct and significant effect on the net compensation amount. It is therefore advisable to consult, at an early stage, with an attorney, certified public accountant, or tax adviser experienced in this field, particularly before drafting a statement of claim, formulating a settlement arrangement, or signing an agreement.
In addition to income tax, depending on the circumstances of the case, withholding tax obligations and the implications of the payment for National Insurance contributions and health insurance contributions should also be examined. In certain cases, questions relating to value added tax (VAT) may also arise, mainly where the payment relates to a service provided and not to compensation paid to an employee. Liability for each type of tax depends on the nature of the payment, the identity of the parties, and the circumstances of the engagement.
When should a tax specialist be involved in an employment claim?
As early as possible, already at the initial stage of assessing the claim. This allows the heads of damage, the factual and evidentiary basis for each component, the drafting of pleadings, the structure of the settlement agreement, and possible withholding and reporting obligations to be reviewed.
Nimrod Yaron & Co. has experience in advising on tax aspects of employment claims and settlement agreements. Before filing a claim, drafting an agreement, or making a payment, it is advisable to examine the classification of the compensation components, the withholding and reporting obligations, and the tax implications for the net amount.
Questions and Answers
Is every payment of compensation received from an employer taxable?
Not necessarily. Compensation paid in the context of an employment relationship may be classified as employment income, but the substance of the payment and the damage or right it is intended to compensate must be examined. In certain circumstances, a specific component may be exempt from tax, partially exempt, or subject to a different tax classification.
Is compensation for emotional distress or non-pecuniary damage exempt from tax?
Not necessarily. The outcome depends on the substance of the compensation, the source of the right, the factual circumstances, the evidence, and the manner in which the component was presented and substantiated in the procedural documents.
Why is it important to address tax aspects already at the stage of filing the claim?
The way in which the statement of claim is drafted may later affect the parties’ ability to substantiate the classification of the compensation for tax purposes. Early review makes it possible to define the damage and compensation components accurately, so that they reflect the legal and factual reality and help reduce potential disputes with the Israel Tax Authority.
Can a settlement agreement also affect the tax rate?
Yes. The drafting of the settlement agreement may affect the parties’ ability to substantiate the classification of the payment components. An agreement that details the substance of each component in a manner consistent with the statement of claim, the facts, and the evidence may help reduce disputes with the Israel Tax Authority, but it does not replace a substantive review of the payment.
Which professionals should be involved in reviewing the tax aspects of an employment claim or settlement agreement?
In such cases, it is advisable to consult professionals experienced in employment law and the relevant tax aspects. Involving professional advisers at an early stage may help reduce uncertainty and improve the economic outcome of the proceeding.
Is it possible to reduce tax after a settlement agreement has already been signed?
Sometimes the tax implications can be reviewed even after a settlement agreement has been signed, but the available room for action may be more limited. Where the agreement does not sufficiently distinguish between the payment components, or where the classification is not supported by the procedural documents, it is more difficult to substantiate, at a later stage, a claim for a different tax classification. It is therefore preferable to examine the issue before signing, when the agreement is being drafted.
What is the first recommended step when considering filing an employment claim that includes compensation components?
The first step is to identify the relevant heads of damage and examine the factual and evidentiary basis for each of them. It is advisable to carry out this review together with the professionals advising on the proceeding, in order to draft the claim accurately and assess in advance the possible tax, withholding, and reporting implications.
Is severance pay taxable?
Severance pay or a retirement grant may be eligible for an exemption up to the ceiling prescribed by law, but eligibility depends on the circumstances of the termination, length of service, salary level, and the amount paid. It is advisable to examine the tax implications before withdrawing the funds or signing an agreement.
Is compensation for sexual harassment taxable?
There is no uniform answer. The source of the right, the nature of the damage, the connection to the employment relationship, and the evidentiary basis must be examined. The label given to the compensation component in the agreement is not conclusive on its own.
Is the Israel Tax Authority bound by a settlement agreement that was approved as a judgment?
No. The Israel Tax Authority is entitled to examine the substance of the payment and the circumstances, even where the parties allocated amounts to specific components in the agreement.
Who is required to withhold tax at source under a settlement agreement with an employee?
Where the payment is classified as employment income or as a payment subject to withholding tax at source, the payer must examine the withholding and reporting obligations before transferring the funds.
