Russian Supreme Court Takes New Stance on Deducting Employee Compensation Upon Dismissal (the EuroChem Case)

13.04.2017

Legal Update No. 594

Goltsblat BLP advises that, on 27 March 2017, the Russian Supreme Court Judicial Board for Economic Disputes (the ”Board”) passed new Ruling No. 305-KG16-18369 on tax case No. А40-213762/2014 (the “Ruling”) involving LLC Mineral and Chemical Company Eurochem (the 'Company'), which will be of major importance to the business community. The case focused on establishing whether it was lawful for corporate taxpayers to deduct severance pay and other (compensation) payments made to their employees upon dismissal for Profit Tax purposes.

The legal position set out in the Ruling clarifies the Board's view as previously expressed in its Ruling No. 305-KG 16-5939 dated 23 September 2016 on case No. A40-94960/2015 (the Parliament Production case) and Ruling No. 305-KG16-17247 dated 17 March 2017 on case A40-186959/2015 (the Russian Regional Development Bank case).

Below we list the points we believe should be recognised as the most significant conclusions in the Ruling:

  • compensation to an employee dismissed under a mutual separation agreement constitutes, inter alia, a kind of payment for the employee's consent to withdraw from the employment contract. For these payments to be recognised as economically justified, it would suffice to establish that the objective is met (i.e., the employee is dismissed) and any potential dismissal-related conflict (such as the employee's refusal to withdraw from the employment contract) prevented;
  • the burden of disclosing evidence confirming the nature of the above payments and their economic justifiability is borne by the taxpayer only if they are clearly inconsistent with the usual severance pay to which an employee is entitled on dismissal under article 178 of the Labour Code of the Russian Federation, the duration, labour input and other characteristics of their employment. That said, in this specific case, the Board recognised compensation of up to five average monthly salaries of the employee to be dismissed as being consistent with the usual severance pay;
  • the tax authority may question the economic justifiability of costs in the form of such payments if proof is available that the taxpayer does not have a business objective in dismissing the employee for any reason other than those specified in article 178 of the Tax Code of the Russian Federation (i.e., not on the grounds of staff reduction or job elimination or liquidation of the company).

Within the meaning of the Ruling, it is most likely that, when their employees are dismissed under a mutual separation agreement, corporate taxpayers may count on the costs of making compensation payments to said employees up to five times their average monthly salaries being recognised as economically justified and deductible. At the same time, even if this condition is met, let alone surpassed, we recommend that taxpayers collect in advance evidence confirming that such payments are economically justified, such as comparative calculations of said sums against expenses to be otherwise incurred in dismissing these employees under the staff reduction or job elimination procedures, and that they expressly state the business objective of said payments in the employment termination agreement (for instance, it may be stated that said payments are intended to achieve conflict-free termination of the employment relations with the employee and constitute payment for termination of the employment contract and that the employee agrees to terminate the employment only subject to being paid the agreed amounts).

Relying on their wealth of experience in advising clients on various aspects of tax treatment of payments due to employees, including upon dismissal under a mutual separation agreement, the Goltsblat BLP tax team are prepared to carry out a pre-assessment of tax risks faced by corporate employers making such payments, to develop recommendations for mitigating said risks and to assist taxpayers during tax inspections.

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