Recognition of severange payments to employees when their employment agreement is determinated: the new position of the Russian Supreme Court

Pepeliaev Group advises of changes in the court practice concerning the recognition of expenses from severance payments made to employees when their employment is terminated.

By its Ruling dated 23 September 2016*  the Russian Supreme Court referred the case of Parliament Production LLC to be reconsidered by the court of first instance. The cause of the dispute was that the employer had unlawfully, in the opinion of the tax inspectorate, included in its profit tax base severance payments made to its employees when their employment had been terminated.

Facts of the case and the history of proceedings

The tax inspectorate disallowed Parliament Production LLC from including in its expenses RUB 3.7 million of severance payments the company paid to employees when their employment terminated by agreement of the parties.

Based on the well-established recent practice of state commercial courts, the courts of first instance and of appeal supported the inspectorate and substantiated their position as follows:

  • severance payments made to employees when their employment was terminated were not connected with their performance of their job duties;
  • employment contracts did not contain a provision for any severance payments to be made on termination: such payments were stipulated by employment termination agreements and supplementary agreements which were signed one day before the employment was terminated.

The State Commercial Court for the Moscow Circuit came down on the side of the taxpayer having considered that the severance payments made to employees whose employment was terminated might be included in the payroll expenses as other expenses because the list of expenses in article 255 of the Russian Tax Code is an open list.

Having considered the cassation appeal filed by the inspectorate, the Panel of Judges for Economic Disputes of the Russian Supreme Court (the “Panel”) quashed the judgments of the lower courts and referred the case to the Moscow City Commercial Court to be reconsidered.

Position of the Panel of Supreme Court

When issuing its decision, the Panel did not confine itself to a formalist approach to the issue and stated that “the nature of payments and their economic justifiability” had to be examined.

Further, it took into consideration the fact that starting from 1 January 2015 amendments to article 255 (9) of the Tax Code came into force. These allowed for the classification as payroll expenses of severance payments and other disbursements to departing employees under employment contracts or separate agreements to them.

When putting forward its arguments, the Panel pointed out as follows:

  • The list of payroll expenses, as provided for by article 255 of the Tax Code, is an open list.
  • Severance payments to employees whose employment is terminated by agreement of the parties may be recorded as expenses even if such payments are made under supplementary agreements or employment termination agreements.
  • However, such payments should meet the requirements set out in article 252 of the Tax Code, i.e. they must be justified and documented. The Supreme Court noted that a taxpayer must justify the amount of payments (especially when it is significant and is not consistent with the standard amount of severance payments) and the purpose which it is pursuing in terminating the employment agreement with a specific employee.

What to think about and what to do

To bolster your legal position we recommend that wordings intended, among other things, to justify the economic reasonableness and the amount of severance payments should be drafted and included in the documents regulating employment relations (internal regulations, policies, employment termination agreements and others). 

In addition to general policies, we recommend that solid arguments be developed on a case-by-case basis. For example, an employment termination agreement with an employee who can establish a competing business may be further justified by imposing certain obligations on the employee.

The new judgment in the case of Parliament Production LLC may significantly affect the approach of tax authorities and courts to the issue of how to prove whether payroll expenses were justified.

Help from your adviser

Pepeliaev Group lawyers possess a wealth of experience in providing comprehensive support to businesses on legal and tax issues connected with employment relations between companies and their employees.

We will be more than happy to draft documents, including template employment agreements and collective bargaining agreements, and to develop the methodology for calculating severance payments to employees. This will help you to reduce the legal risks in connection with your applying employment and tax legislation.

Ruling No. 305-KG16-5939 of the Russian Supreme Court dated 23 September 2016 in case No. A40-94960/2015.

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