Is severance pay subject to VAT?

Czech Republic: According to the courts, where severance pay serves to compensate previously rendered performances, it is subject to VAT

The Supreme Administrative Court reviewed the issue of whether the severance pay agreed in a termination agreement was subject to VAT (case file No. 8 Afs 30/2013).

Under a contract made with the City of České Budějovice (as the principal), the plaintiff (as the contractor) was originally supposed to revitalize a former barracks compound, by tearing down the old barracks and erecting new buildings. In the course of work on this project, however, the city decided to terminate the contract with the plaintiff and to go forward with the revitalization with the help of a new contractor. At that time, the plaintiff had already completed the demolition of the original barracks, though construction work on the new buildings had not yet begun. The parties entered into an agreement to terminate their cooperation in which they agreed on a severance payment. The dispute at hand revolved around the issue of whether this payment was subject to VAT or not.

The plaintiff argued that the character of the payment was that of compensation for damage, in the form of expenses made in vain towards an unrealized development project, which is why the payment should not be subject to VAT. According to the plaintiff, the case at hand was one of a frustrated investment, in that the plaintiff had de facto been forced to terminate the cooperation. The plaintiff also argued that no specific agreement had existed for the performance of the demolition work.

The tax office in the role of the defendant countered that the payment that had been made was taxable as it constituted consideration for the actually performed demolition work (as a part of the project), which represents value enjoyed by the City that can be expressed in monies. For the finance office, the added value lies in the fact that the City won’t have to arrange for the demolition of the barracks through a third party.

The Regional Court, and in due course the Supreme Administrative Court, confirmed the view of the tax office as essentially correct according to which the payment is subject to VAT. In the words of the Supreme Administrative Court, it is of no relevance how the reason for the payout is labeled in the termination agreement. Of decisive importance is its true character. The project doubtlessly sought to revitalize a certain property by erecting new buildings, and in this sense, the court found, the demolition works which preceded the development (and made it possible in the first place) also made the property appreciate in value.

Against this backdrop, we recommend a careful review of every transaction where a severance payment / financial “exit settlement” is performed as to whether the payment is strictly for no counter-performance. In the opposite case, the VAT implications will have to be considered.

Source: Decision 8 Afs 30/2013 of the Supreme Administrative Court

Radka Šlancarová, Tax Advisor

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