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Puerto Rico Supreme Court Issues Opinion Regarding Tax of Separation Payments
In 2009, the Puerto Rico Supreme Court (the "Court") issued an opinion in connection with an issue which had been present for a long time: what is the income tax treatment of payments received prior to 2006, by an employee under Act No. 80 ("Act 80") upon his/hers separation from employment. In this article, we will discuss that decision. Taxand Puerto Rico examines the Supreme Count issues and compensation agreements between an employee and his/her employer.
I. Applicable Law
Act 80 provides, among other things, that compensation must be paid to employees who are dismissed without just cause. Said compensation cannot be subject to any payroll deductions and must be delivered in full to the employee. Among the payroll deductions applicable in Puerto Rico are: (1) Puerto Rico income taxes, and (2) U.S. Social Security ("FICA") taxes. In 2008, Act 80 was amended to provide that amounts received by an employee upon a justified dismissal (not a dismissal without just cause) will be considered a special compensation and will be exempt from Puerto Rico income tax withholding and the payment of Puerto Rico income taxes.
The Puerto Rico Internal Revenue Code (the "PRIRC"), as originally enacted, provided, among other things, that amounts received as compensation for personal injuries or sickness, and any damages received as a result of such injuries, were excluded from gross income and, thus, were not subject to Puerto Rico income taxes, including income tax withholding. It also provided that compensation paid under Act 80 was not wages and, therefore, was not subject to income tax withholding at source. In 2006, PRIRC Section 1022(b)(5) was amended to provide that only the compensation for personal physical injuries or physical sickness is excluded from gross income.
II. Background History
Many taxpayers who received compensation under Act 80 (as a result of a court action or a release/settlement agreement) excluded the amount received from gross income and did not pay income taxes thereon. They argued that the compensation received under Act 80: (1) was not subject to income tax withholding (as provided by both Act 80 and the PRIRC), and (2) was not subject to Puerto Rico income tax (because it was not subject to income tax withholding at source and was compensation received for personal damages resulting from the unjustified dismissal).
The Puerto Rico Secretary of the Treasury (the "Secretary"), however, had a different position regarding said matter. In the Administrative Determination 98-01 (the "AD 98-01"), she indicated that compensation received pursuant to Act 80 is not considered compensation for personal injury or sickness (as required by PRIRC Section 1022(b)(5)), and, accordingly, is gross income subject to Puerto Rico income taxes.
Some taxpayers, however, did not agree with the AD 98-01 and continued to exclude from gross income the compensation received upon termination of employment from a claim under Act 80 or pursuant to a release/settlement agreement including, among others, a possible action under Act 80. The controversy reached the Puerto Rico Circuit Court of Appeals (the "Circuit Court") which considered the income tax treatment of certain payments that an employee received as compensation, upon entering into a release agreement (the "Agreement") with his employer in connection with the termination of his employment covering, among others, a possible claim under Act 80. In that case, the Circuit Court rendered a judgment in which it stated that the purpose of the Agreement was to prevent a possible court action under Act 80 and any other applicable acts, and determined that the amount received was not wages, and that it provided compensation for a harm done or a loss sustained as a result of the termination of employment. Based on that, and on the provision of the PRIRC that exempts compensation for personal injuries from income taxes, it concluded that the amount received by the employee was exempt from the payment of income taxes. Said judgment was not appealed by the Secretary to the Court.
The Secretary, however, did not agree with that judgment, and in 2007 issued the Administrative Determination 07-01 (the "AD 07-01") which, among other things, reaffirmed that compensation received under Act 80, although not subject to income tax withholding, is gross income subject to Puerto Rico income taxes.
Various taxpayers, based on the Circuit Court decision, continued to exclude from gross income amounts received upon termination of employment, which resulted in income tax deficiencies issued by the Secretary and court actions by the taxpayer contesting them. One of those actions reached the Court and is the subject of the opinion that is analysed herein.
III. Orsini vs. Secretario de Hacienda
In the Orsini case, the Supreme Court considered the following facts.
Mr. Francisco Orsini (the "Employee") worked for a pharmaceutical corporation (the "Employer") and after 10 years of service, he was dismissed in 2003. As part of the dismissal process, the Employer offered him certain amount of money if he signed a document entitled Release Agreement (the "Agreement"). Pursuant to the Agreement, the Employee would release the Employer from any responsibility that it may have in connection with his employment and its termination. On the same date that the Employee signed the Agreement, the Employer gave him the agreed amount (approximately $163,000, the "Compensation") upon which it withheld approximately $32,000 of Puerto Rico income taxes.
In the income tax return for taxable year 2003 (the taxable year in which the Employee received the Compensation), the Employee reported the Compensation as income and paid Puerto Rico income taxes thereon. Subsequently, he filed an amended income tax return for said taxable year in which he excluded the Compensation and requested a refund of approximately $32,000 (the amount of income taxes that was withheld by the Employer). As basis for his claim for refund, the Employee argued that the Compensation was not wages, thus, was not taxable and, therefore, that the Employer improperly withheld income taxes from it. The Secretary denied the refund that the Employee claimed in his amended income tax return, and, instead, issued a final notice of deficiency in connection therewith.
The Employee, on his part, filed a complaint in trial court contesting the deficiency, in which he raised the same arguments presented to the Secretary in support of the refund claim. The Secretary opposed the complaint arguing that the amount received was neither compensation in connection with a personal injury or sickness (as required by PRIRC Section 1022(b)(5)) nor compensation for damages under to the Civil Code. Therefore, he concluded, the Compensation was taxable.
The trial court decided in favour of the Secretary. The Employee, however, appealed to the Circuit Court, which revoked the trial court's judgment and ordered the Secretary to reimburse the income taxes the Employee paid in connection with the Compensation. The Secretary did not agree with said decision and filed a petition for review with the Court, which was granted.
In a unanimous decision, the Court held, among other things, that the Compensation was not taxable for Puerto Rico Income tax purposes.
Criteria for Interpretation to be Applied
Initially, the Court discussed the criteria to be used while interpreting the issue presented in the case, which involved a tax (the PRIRC) and labour legislation (Act 80). According to the Court, the labour legislation should be interpreted liberally, while the tax statutes regarding exclusion from gross income (such as PRIRC Section 1022(b)(5)) must be interpreted restrictively. The Court found that it is not clear if under the PRIRC, the compensation received under Act 80 is excluded from gross income or not. Therefore, the Court indicated that it will interpret those two acts so that the legislative intent of the PRIRC provision can be achieved.
The Court stated that all types of compensation paid upon a dismissal have the same objective: to respond for the damages caused from the loss of employment. It further indicated that payments under Act 80 (the "mesada") result from the legal obligation that the employer has to compensate an employee for an unjustified dismissal. The Court then concluded that the compensation received by the Employee under the Agreement was a payment under Act 80.
Income Tax Treatment
Finally, the Court discussed the income tax treatment of the compensation paid under Act 80. It accepted that the definition of gross income under the PRIRC is broad, and that for an item to be considered gross income it must be a gain, a benefit or income produced by or resulting from work or capital or income derived from any source. The Court affirmed that wages are subject to income tax withholding, but that payments under Act 80 are not wages and that no payroll withholding shall be made there from. In this respect, the Court cited the case of Alvira Cintr?n vs. SK&F in support of the conclusion that payments under Act 80 are not subject to FICA tax withholding.
The Court then considered whether the compensation paid under Act 80 is income derived from any source and, thus, gross income upon which the taxpayer must pay income taxes. In this respect, it indicated that compensation received for personal injuries is not gain and is not subject to income taxes. Under that frame of mind, the Court analysed the DA 98-01 and concluded that the interpretation made by the Secretary therein is extremely unjustified and restrictive.
The Court, then, entered into a discussion of PRIRC section 1022(d)(5). In this respect, it analysed the term "damages" and concluded that the concept is applicable to a dismissal because it has adverse effects in the life of an employee who is dismissed. Based on that, the Court concluded that the dismissal payments under Act 80 resulting from a judicial claim or out of court settlement are exempt from income taxes since they qualify for the exclusion from gross income applicable to the compensation which pretends to make whole for a personal injury or sickness.
After the Court's decision in Orsini it is clear that amounts received by an employee under Act 80, resulting from a court action by the employee or from a release/settlement agreement between an employee and his/her employer, prior to the effective date of Act 117 (see note 13), is not gross income and is not subject to Puerto Rico income tax withholding nor the payment of income taxes. In view of that, taxpayers who received Separation Payments and paid income taxes thereon should consider whether to file a claim for refund, if the statute of limitations for filing such claim has not expired.
Since the case involved a payment that was received before Act 117 amended Section 1022(b)(5), it is not clear what is the tax treatment if such type of payment is received after the effective date of the amendment. It is not clear either if dismissal payments that are not related at all to Act 80 will have the same tax treatment as that given to the Employee in the case. Finally, since the Court cited with approval the Alvira case (notwithstanding the federal law and the expressions of the Puerto Rico Federal District Court to the contrary (see note 17)), it is not clear if for Act 80 purposes, payments made there under can be subject to FICA tax withholding, nor the possible consequences if the employer makes such withholding.
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