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OECD works on new comments on tax treatment of termination payments
A draft paper was released for public discussion by September 2013 – the feedback to which is being analysed by the OECD Tax Treaties division. Ahead of the release of the final paper, the proposed tax treatment for the most relevant termination payments at this stage is outlined below.
According to the draft paper released, the OECD is reviewing the tax treatment of several types of termination payments. Companies should look closely at the proposed regulation of the following types of payments, and assess the potential impact of these new rules, as explained below.
Severance payments should fall under Article 15 and be allocated, in principle, to the source State where the employment was exercised on the date of termination. Typically, the severance payment will be allocated to the last year of employment. However, this does not preclude allocation to previous years of employment where the facts and circumstances would make that possible and appropriate.
Damages for unlawful dismissal
Severance payments that are required by law for an unlawful dismissal would fall under Article 15. Damages, however, seeking other types of compensation (ie discriminatory treatment, reputation, punitive), may fall under Article 21 (other income – taxation in the State of residence) or even Article 13 (capital gains).
Non-competition payments will usually be taxable only in the State where the recipient is tax resident during the period covered by the payment. This is because, in most cases, this remuneration does not strictly derive from the services rendered while the employment was active. However, in the case that the remuneration for non-competition is included in the salary and wages received while being employed (or when the non-competition obligation is of little or no value to the ex-employer) payments will be treated as any other remuneration under Article 15.
Payments related to pension rights
Pension payments will usually fall under Article 18 (taxation in the State of residence rule). However, in certain cases, they may fall under Article 15, such as the reimbursement of pension contributions (ie after temporary employment), which would constitute an additional remuneration for the services rendered while the employment was active.
Deferred remuneration should be treated as income covered by Article 15 and, to the extent that a payment could be associated to a specific period of past employment in a given State, it should be considered to be derived from the employment activities in that State.
Incentive compensation arrangements
The OECD proposes that payments under incentive compensation arrangements should follow the treatment established for employee stock options in paragraphs 12 to 12.15 of the Commentaries to Article 15 of the OECD Model Tax Convention.
The OECD draft paper also deals with the tax treatment applicable to other payments such as:
- remuneration for previous work
- payment of unused holidays or sick leave
- payment in lieu of notice of termination
- fringe benefits for the period after employment
- compensation for loss of earnings on or after termination following injury or disability
- compensation for loss of future commissions
- partial retirement payments
Gonzalo Fernández de Lorenzo
T. + 34 91 514 52 00
Quality tax advice, globally
HR, finance and tax staff within MNCs are familiar with the various tax impacts that may derive from managing a mobile workforce across various countries. The tax treatment of various types of payments that may take place after the termination of employment is still a subject for careful analysis, where clear guidelines are not commonplace. In addition, there are remarkable differences in the way that the statutory employment regulations of the different countries treat the termination of a labour contract.
In order to clarify the tax treatment of those payments that are usually seen after the cessation of employment (included, but not limited to, severance payments and non-competition payments), the OECD is working on changes to the commentaries to Article 15 and Article 18 of its Model Tax Convention., MNEs should look closely at the proper categorisation of those cessation payments according to the initial draft paper released, in order to distinguish from the more commonly seen pension payments, as well as at the proper allocation of payments to the year the employment was terminated or to previous years (pro-rata rule).
The Taxand global compensation tax service line will follow up any developments in this area before and after the final OECD paper is released.