Read About Lawsuits Against Employers or Compensation for Sexual Harassment – and Tax Aspects
As a general rule, any legal victory in a business context or within the scope of employment relationships constitutes taxable income. The basic rule states that “the nature of compensation is the same as the income it replaces.” This means that when the compensation is derived from employment relationships, it is taxable as employment income. However, in every lawsuit, there are certain components that are not taxable or are taxed at a reduced rate, and it is important to recognize them.
Engaging a tax expert in the early stages of the lawsuit, even before filing the claim, will ensure the correct division of the lawsuit components so that it does not affect the legal essence but helps reduce taxes on the award money.
When it comes to compensation for mental anguish and sexual harassment, which essentially do not constitute earnings or work-related income, and do not fall under any other income listed in the Income Tax Ordinance, they are not taxable income, and there is no basis for taxing them.
In Administrative Petition (TA) 53681-12-16 Moshe Shachaf v. Income Tax Assessor Gush Dan, it was determined that compensation given to an employee for sexual harassment at the workplace does not constitute income for the employee, even though it was paid by the employer and within the framework of employment relationships. The compensation was intended to compensate the employee for the wrongdoing caused at the workplace, in accordance with the principle underlying tort compensation, i.e., restoring the previous state.
Similarly, in ITA 1146/03 Davidovich v. Income Tax Assessor Netanya, it was ruled that an amount constituting compensation for mental anguish is not taxable. In the Davidovich case, it was determined that an amount of NIS 158,000 received by the appellant was not taxable, being compensation for other damages of the appellant that are not from a taxable source. The income tax assessor’s claim that the entire disputed amount arose solely from the employee-employer relationship was not accepted, as the settlement agreement addressed all the appellant’s claims against the employer, including damage to his good name and mental anguish.
Often, the biggest challenge is proving the facts of the case to the tax assessor, as such settlement agreements often end with a waiver of all claims raised in the lawsuit and a confidentiality commitment. Therefore, the wording of the claims or settlement agreement can impact the tax rate – explicit division of components for mental anguish or, as appropriate, for sexual harassment can allow for avoidance of tax liability on these components. For other lawsuit components, it is possible to draft terms that align more closely with capital income versus regular income, which have different tax rates, as is known, for interest and index differences (interest is taxed at a lower rate, and index differences are exempt).
Our office advises on the correct wording and separation of components to achieve maximum tax savings. If possible, it is advisable to consult before the court ruling to ensure proper wording and attribution already in the pleadings/settlement agreement.
Our office has extensive experience in handling such cases with the tax authorities; opinions we have written on these subjects and settlement agreements reached with the tax authority have saved our clients hundreds of thousands of shekels in taxes and reduced the tax paid in some cases from 50% to an average rate of around 17%.
In one case, it involved a senior employee at one of Israel’s largest companies who received millions of shekels in compensation for “hush money” for sexual harassment she suffered. The tax authority claimed it was employment income and should be taxed at the maximum marginal tax rate and additional surcharge (over 50% tax).
In our opinion, we divided the lawsuit amounts into components that, in our view, reflect the correct factual situation, resulting in significant tax savings. In this case, we conducted prolonged discussions, ultimately saving more than two-thirds of the tax initially demanded by the tax authority – demonstrating once again that it is important to consult with a tax professional – a CPA, lawyer, or tax advisor.
Need advice? Contact us. Almost every case dealing with labor law has implications related to income tax. Early consultation can save a lot of money. Our office maintains regular collaborations with law firms specializing in labor law and provides them with initial free advice regarding tax aspects in their cases.
