The Council of State’s Decision on Notice Payments Under a Mutual Rescission Agreement
The decision of the Council of State Board of Tax Law Chambers, dated 27.01.2021 and numbered 2020/17 E. 2021/2 K. (“Decision”) given upon the request to resolve the conflict between different Regional Administrative Courts was published in the Official Gazette dated 09.09.2021 and numbered 31593. In this article, the legal context of the Decision, the court’s reasoning, and its assessments will be analyzed.
Request to Resolve a Conflict Between Regional Administrative Courts
The board of Presidents of the Ankara Regional Administrative Court through its decision dated 10.07.2020 and numbered 2020/63 E. 2020/63 K., approved the claim of the applicant and the request to resolve the disagreement between decisions of Regional Administrative Courts of different jurisdiction areas regarding the issue “whether the payment in lieu of notice made to the employee under a mutual rescission agreement will be considered as a salary and thus, will be subjected to the income tax.” Going through the relevant statutory provisions may be helpful before proceeding with the analysis of the facts and reasoning of the Decision.
As defined in Article 32 of the Labor Law numbered 4857 (“Labor Law”) a salary is the amount of money to be paid in cash by an employer or a third party to a person in return for a service. Article 17 contains rules and regulations with regard to the payment in lieu of notice. Pursuant to this article, before terminating a continual employment agreement made for an indefinite period, notice must be served by the party which terminates the agreement. The agreement shall then terminate: i) for employment agreements lasting less than 6 months, 2 weeks after the notice, ii) for employment agreements lasting between 6 months and 1,5 year, 4 weeks after the notice, iii) for employment agreements lasting between 1.5 year and 3 years, 6 weeks after the notice and iv) lastly, for employment agreements lasting more than 3 years, 8 weeks after the notice. A party which does not comply with the requirements of serving notice shall pay compensation covering the salary which corresponds to the notice period specified in Article 17 of the Labor Law. This compensation is known as a “payment in lieu of notice” or a “notice payment.” During the notice period, there will be no change in parties’ conditions and thus, all rights and obligations between the employee and employer will remain the same. The employer may terminate the employment agreement with immediate effect by paying in advance the salary corresponding to the notice period.
A mutual rescission agreement (also known as an abrogation agreement) is not one of the methods of terminating an employment agreement, regulated under the labor legislation. However, in practice, within the framework of contractual freedom, parties have the opportunity to terminate an employment agreement by mutual consent. Due to the lack of legislation concerning the conditions under which such agreements are valid, their scope and consequences are determined by scholarly articles and the precedents of the Court of Cassation.
On the other hand, salary is defined in Article 61 of the Income Tax Law numbered 193 (“ITL”) as a certain amount of money and benefits provided in return for a service to employees who work subject to an employer and in association with a specific workplace, as well as benefits which are capable of representation in monetary terms. The payment of the salary as allowance, compensation, cash indemnity, allocation, salary increase, advance, dues, daily allowance, premium, bonus, or for expenses or otherwise, or determining the salary as a certain percentage of the income (unless it is related with a partnership), will not have any effect on the nature of the salary. According to the same article, money given in return for a service to be provided in the future is also considered a salary. The amendment made through The Law Amending Tax Laws, Certain Laws and Certain Decree Laws numbered 7013, (“Law No. 7103”) on 27.03.2018, a new paragraph was added to Article 61 of the ITL titled "Description of Salary and clarified that any payments made after terminating an employment agreement, including compensation made within a mutual rescission agreement or abrogation agreement, job loss indemnities, compensation for job security, or severance allowances, will also be classified as a salary.
Withholding is regulated under Article 94 of the ITL. Pursuant to this article, public agencies, public economic organizations and other institutions, commercial companies, joint ventures, associations, foundations and their commercial enterprises, traders, and self-employed persons who are obliged to state their real income, Salaries paid to employees and payments listed in Article 61 that are considered to be salaries -not including exceptions- are considered payments to be withheld. Tax withholding is determined according to graduated tariffs calculated through Article 103 and 104 of the ITL.
As per Article 25 of the ITL, some compensations and benefits are exempted from income tax. Severance payments are one example. The exemptions from income tax have been increased through the amendment of this article in 2018 and 2019 by Law No. 7103 and The Law Amending the Income Tax Law and Certain Other Laws numbered 7162 (“Law No. 7162”). Pursuant to these new laws, payments and benefits such as compensation of non-reinstatement, death, disability and sickness compensations, compensations paid within the scope of a mutual rescission agreement, job loss indemnities, severance allowances, and job security indemnities, are exempted from income tax (up to the legal cap of the severance payment). Any payments and benefits which exceed the cap are still subject to income tax.
Regional Administrative Court Decisions Subject to the Decision
The conflicting decisions of the Regional Administrative Court are included in the Decision along with the reasoned decisions of the courts of the first instance. Within this context:
- The decision of 1st Tax Law Chamber of the Ankara Regional Administrative Court dated 22.01.2020 and numbered 2019/1152 E. 2020/62 K. and the decision of 1st Tax Law Chamber of the Istanbul Regional Administrative Court dated 07.05.2018 and numbered 2018/762 E. 2018/1320 K. both state that payment in lieu of notice is not in return for a service; instead it constitutes a penal clause for the purpose of complying with the term of an agreement. Consequently, the courts concluded that the notice payment does not satisfy one of the conditions listed in Article 61 of the ITL which is “being in return of service.” Furthermore, they explained that the name under which the non-wage payment is made does not matter in terms of taxation, and thus it is a taxation fault to make an income tax withholding over the notice payment.
- The 2nd Tax Law Chamber of the Istanbul Regional Administrative Court, in its decision numbered 2019/1250 E., emphasized that the salary paid to an employee in return of service needs to be broadly interpreted and deemed as salary by considering the fact that the employee will still continue to work under the employer in cases where the notice period is complied with.
Justification of the Decision and Legal Assessment
The contradiction between the decisions subject to the request is related to whether the notice payments made to a terminated employee under mutual rescission agreements signed before 27.03.2018 (in other words the effective date of Law No. 7103) are considered salary or not. Therefore, the Council of State Board of Tax Law Chambers analyzes Law No. 7162 and Law No. 7103 with their non-amended versions. The results of the Council’s legal assessment are as follows:
- Expanding the application of provisions of exceptions and exemption clauses in the field of taxation would be contrary to principle of legality. Under the ITL, all income that satisfies the conditions of a salary and which is not exempted from taxation should be taxed.
- As per Article 8 of Tax Procedural Law numbered 213 (“TPL”), a legal status which is defined as a taxable event cannot be changed by a private law transaction, except for the exceptions stipulated in the law.
- Tax legislation needs to be interpreted by considering both the letter and spirit of the law.
- Since it is not possible to make an exception for a salary which is not subjected to taxation, “compensations and benefits” which are exempted from taxation under the ITL should be considered as salary.
- Parties may decide to pay in advance for a benefit, in return for a service which will be provided in the future (in other words, notice payment). On the other hand, it is also possible for an employee to work within the notice period and terminate the employment relationship at the end of the period. The income generated from this service constitutes a salary.
- Although the salary to be paid in return for a service in case of compliance with the notice period is considered salary, the fact that the notice payment is not accepted as a salary creates a difference in terms of taxation.
- Consequently, under Article 61 of the ITL, the notice payment within the scope of a mutual rescission agreement signed before 27.03.2018 is salary and therefore, it is subject to income tax withholding.
It is clear that the Decision have clarified the existing discrepancies and contradictions in practice regarding the taxation of notice payment made under mutual rescission agreements concluded prior to 27.03.2018. The assessments in the Decision provide guidance related to the question of whether compensation and receivable amounts determined by mutual rescission agreements will be subjected to income tax or not. In addition, it should be noted that pursuant to the Provisional Article 89 of the ITL, income tax collected as compensation within the framework of a mutual rescission agreement prior to 27.03.2018, will be rejected and returned as a result of the application of an employee within the statute of limitations. In the event that a tax, which is subject to TPL and must be refunded pursuant to a judicial decision after collection, is requested to be returned together with "legal/statutory" interest without any legal basis, "deferment" interest that is regulated under Article 112/4 of the TPL should be regarded.