Generally, winning a legal proceeding in a business context or in the context of employment relations constitutes taxable income. The basic rule states that “the nature of the compensation follows the breach it intends to remedy.” This means that when the source of the compensation is employment relations, the compensation is taxable as employment income.
However, in every claim, there are certain components that are either not taxable at all or are subject to reduced taxation, and it’s important to be familiar with them. Involving a tax expert in the early stages of the claim, even before filing the claim, will ensure the correct separation of the claim’s components so as not to affect the legal substance, but to help reduce tax on the compensation amount.
Compensations for emotional distress and sexual harassment
Compensations for emotional distress and sexual harassment do not constitute wages or profit from work, nor any other income listed in the Income Tax Ordinance. Accordingly, they do not constitute taxable income and there is no basis for their taxation.
In the case of Moshe Schach vs. the Tel Aviv District Tax Officer (Central Administrative Petition Tel-Aviv 53681-12-16), it was determined that compensation given to an employee for workplace sexual harassment shall not constitute income for the employee, despite being paid by the employer, and despite being paid within the framework of employment relations. The compensation was essentially intended to compensate the employee for a wrong suffered at their place of work, according to the principle underlying tort compensations, namely, the restoration of the original situation.
Similarly, according to the verdict in the Davidovitz vs. the Netanya District Tax Officer case (Supreme Court Appeal 1146/03), an amount that constitutes compensation for emotional distress is not taxable. In the Davidovitz case, it was established that a sum of 158,000 NIS received by the appellant was not taxable, as it was payment for the appellant’s other damages, not originating from a taxable source. The Tax Officer’s claim that the entire disputed sum derived solely from employer-employee relations was not accepted, as the settlement referred to a comprehensive range of claims the appellant had against the employer, including defamation and emotional distress.
The importance of proving facts
Often, the major challenge is to prove the facts of the case to the Tax Officer, since such settlements often conclude with the relinquishment of all claims raised in the lawsuit and a commitment to confidentiality. Therefore, the way claims or settlement agreements are worded may affect the tax rate – an explicit split of components for emotional distress or, where appropriate, for sexual harassment, will allow avoidance of tax liability for this component. As for additional components of the claim – wording that aligns more with capital income as opposed to income from yields, which have different tax rates, interest, and linkage differences (interest is subject to lower tax and linkage differences are exempt), may be advantageous.
Our office advises on the correct wording and separation of components in a manner that leads to maximum tax savings. If possible, it is advisable to consult before reaching a court decision to ensure the correct wording and attribution already in the claim documents / settlement agreement. Our office has extensive experience in managing such cases against the Income Tax Authority, and the opinions and settlements we have reached with the tax authorities have saved our clients hundreds of thousands of shekels in taxes, reducing the tax paid in certain cases from 50% to an average rate of about 17%.
In one case, it involved a senior employee at one of Israel’s largest companies who received millions of shekels in compensation for “silence money” due to sexual harassment she suffered. The Income Tax Authority claimed that this constituted employment income and should be taxed at the maximum marginal rate plus additional tax (over 50% tax).
In our opinion, we split the claim amounts into components that, in our view, reflect the correct factual situation, significantly saving on taxes. In this case, we conducted prolonged discussions, ultimately saving more than two-thirds of the tax initially demanded by the Tax Authority.
Almost every case involving labor law has implications related to income tax. Consulting as early as possible can save a lot of money. Our office maintains regular cooperation with labor law firms, providing them with initial consultation free of charge regarding the tax aspects of the cases they handle.
