9 watch-outs for termination of employment of (international) employees
Dennis Reins on practical essential points of attention when terminating employment of international employees. What are the employer and employee risks? What can you do to avoid the risks?
Termination of employment has a lot of impact, personally but often also financially. There could also be a number of personal or employer tax issues that are often overlooked. Dennis Reins of TTT-Group discusses 9 points of attention employees and employers need to be aware about in view of a termination of employment. Dutch tax rules can be quite complex and can also have a high impact. Special attention goes out to employees with the 30% ruling and other kind of “international” employees.
1. Penalty tax #1 (excessive remuneration tax)
There are certain specific rules on excessive remuneration in the Netherlands. A particularly important one is that employers may need to pay 75% (!) on (part of) a severance pay or options that an employee may still exercise. This has all to do with legislation aimed to discourage excessive remuneration. Via some very complex rules, the employer tax is calculated on the considered excessive income part. As the employee is already normally taxed on all his earnings, including the excessive part, the employer tax is additionally due and therefore called pseudo-levy (as it does not replace the taxation at employee level). Part of the earnings are thus taxed at maximal 127%, being 52% wage tax paid by the employee and 75% payable by the employer.
This specific legislation applies if the employee earned over € 538,000 (2016) on an annual basis in the second year before the termination year. If it is less, the legislation is not triggered and there is no employer tax due. But if it is higher, employer tax may be due. To put it simply, this is the case if the severance pay paid in the termination year and any increases in salary in year t-1 and year t (compared to the income in year t-2) exceed the income level in t-2. On the excess, the employer is due 75%. There are several specific detailed rules when an employment started or ended during a year, or started only last year or in the same year. Also, specific rules apply for options. Options that have been granted in the termination year or in the year prior to termination are also considered at fair market value when these have not been exercised before or at termination date.
John earns € 600,000 in 2014 (t-2) and € 700,000 in 2015 (t-1). On December 31, 2016 his employment is terminated. In 2016 (t) he earned € 650,000 and received a severance pay of € 850,000. The income in year t-1 is € 100,000 higher than in year t-2. The income in year t is € 50,000 plus € 850,000 = € 900,000 higher than in year t-1. The penalty tax due is calculated as follows: € 1,000,000 (€ 100,000 plus € 900,000) minus € 600,000 = € 400,000 x 75% = € 300,000.
I have often experienced that discussions between employees and employer have become very difficult because of this specific type of legislation or that employers were simply not aware of these high-impact rules.
Check if the penalty tax could be due. The impact can be highly significant. Planning and timing may certainly help minimizing or avoiding the penalty tax. Specific attention must be given to cross-border employees (e.g. expats, US nationals or commuters) as there may be more possibilities to limit the impact.
2. Penalty tax #2 (pre-pension tax)
Another important pseudo-levy is a 52% employer tax due on severance pay that qualifies as pre-pension. The Dutch legislator is penalizing employers who pay an amount to leaving employees if the earnings are sufficient to bridge the period between termination date and the normal pension date. Employers may argue that the levy is not due since either the amount is too low to bridge the pre-pension period or that the termination has a clear (real) business reasons and the severance was not based upon bridging the pre-pension period.
Similar as the other penalty tax, the employer has to pay 52% tax whilst the employee is also due maximal 52% tax.
Check if the penalty tax could be due. Reconsider, think about the motivation and/or adjust the severance pay level before anticipating a termination of employment of employees older than 55 years of age and entitled to a large severance pay.
3. Global tax and/or social security position of employee
In practice I have experienced often that a termination of employment was not optimized which has cost both the company and the employee more money than needed. Therefore, it is recommendable to gain a good understanding about the tax and social security implications (besides the legal aspects of course). This is especially true for cross-border employments, holders of the 30% ruling (see further below) and for employees who consider to move to another country in view of their termination of employment.
For example, if an employee would move to another country before the severance pay is paid, this could result into an additional tax or social security liability than if the employee would have waited with moving after the employee received his severance. Such additional tax liability could, for instance, arise since the new home country (with higher tax rates) has a credit system for the avoidance of double taxation (in which case the employee will pay additional tax on top of the tax already paid)(1). Or the new country is a country with which no tax treaty exists or is not applicable. Similarly, an additional social security liability may arise in the new country in exceptional circumstances. The message is clear, global movements or global mobile workforce require specific attention when terminating an employment agreement.
Be aware of the risks and complexities that may arise when working and/or living abroad. With proper tax planning and obtaining proper tax advice, risks and increased tax impact may be avoided or minimized.
4. 30% ruling: income from past employment / post-termination income
The 30% ruling is not applicable on income from past employment. Severance pay is considered as income from past employment and, hence, the 30% ruling is not applicable.
The 30% ruling is, however, applicable on income from current employment. In principle this also applies on post-termination income, such as bonus, pay-out of outstanding vacation days and holiday allowance provided this is taxable/paid within one month following the month of termination. If it is paid/taxable later, the 30% ruling is not applicable.
Stock options/SARs or vested stock require specific attention. In principle, accelerated vesting should be fine for applying the 30% ruling (provided that the taxable moment is within the one month period) as this qualifies as income from current employment. But if the employee loses its entitlements to (unvested) equity and in fact gets (cash) compensation for the loss of equity, such compensation is considered as severance pay / income from past employment in which case the 30% ruling is not applicable.
Employers should be really careful in applying the 30% ruling on payments made in light of termination of employment. Timing and nature of the payments are decisive for the possibility to claim the 30% ruling.
5. Gardening leave & 30% ruling: very tricky!
Gardening leave deserves to be specifically addressed. The Dutch tax authorities (DTA) are of the opinion that gardening leave payments qualify also as income from past employment (since the active employment stopped). Case law is dynamic in this area and it is still unclear whether the DTA’s view is correct and whether certain conditions must be met before gardening leave is considered as income from past employment.
Due to the DTA’ position, the combination of the 30% ruling and gardening leave is quite tricky. There are 3 risks involved:
- The 30% ruling may not be applicable on salary received during inactive months;
- The employment can be considered already actually terminated in which case the 30% ruling also ends. The 30% ruling can only be applied then on post-termination income that is paid/taxable within the one month period (referred to in paragraph 4). Thus, it can greatly jeopardize also the application of the 30% ruling on income that is considered income from current employment but which is paid/taxable later than one month following the month in which the active employment activities are terminated.
- Another risk following the view that the employment actually already ended, is that continuation of the 30% ruling with another Dutch employer when there is more than 3 months’ time between the start of gardening leave and concluding of a new employment agreement with a new employer.
Try to avoid agreeing on gardening leave for employees with the 30% ruling. If this is not possible, then try to limit the period and seek possibilities to already (partly) pay post-termination income within one month following the end of active employment and allow immediate exercise of options. If this cannot be done, it is advisable to employers not apply the 30% ruling anymore after the one month period.
6. OECD commentary and sourcing of taxation rights
On the basis of the most recent OECD commentary regarding severance pay, a severance pay is in accordance with the OECD Model tax treaty taxable in accordance with the taxation rights on regular income in the 12 months preceding termination of active employment. The commentary also provides guidelines for other payments in view of termination of employment, such as gardening leave (taxable on the basis of where someone would have normally performed the working activities if the employment was not terminated). This commentary is likely applicable in most situations where tax treaties, based on the OECD Model tax treaty, have been concluded between countries. Therefore, it must be determined to what extent the severance pay is actually taxable in the (former) work and/or (former) residence state(2).
However, besides that the commentary is not binding (but has very important interpretative power), the commentary is rather new (i.e. 15 July 2014) and not all countries will adopt this new commentary (as these countries may not apply a dynamic interpretation). Instead, countries may adopt a static interpretation, meaning that the new commentary is not considered, or for other reasons may follow their own guidelines and case law.
Be aware of the new OECD commentary that sources taxation rights on a severance pay in conformity with taxation rights on employment income in the 12 preceding months. Please check whether the involved country or countries adopt the new commentary.
7. Waiver vs tax equalisation agreement
Special attention is required for employees who have been working on basis of tax equalisation (TEQ). Under such agreement, employees may need to pay back any tax (or social premium) refunds for past years and current year on income to which the TEQ applies since any tax liability in this income is for the account of the employer. As tax returns are filed after the tax year and final tax assessments are raised much later, it can easily take a few years before such TEQ settlements are finalized.
It is common, in case of termination of employment, to conclude a termination contract in which it is stated that this is a final settlement and which supersedes all prior contracts. As such, including such a clause can result therein that employees who are still entitled to a tax refunds will not want to pay back such refund to the employer. Sometimes the tax refunds could be very significant. The employee could take the position that the former TEQ agreement made is not valid anymore as of signing of the final termination / settlement agreement. This may result in unforeseen financial implications and tax authorities may argue that the employer has granted a net benefit to the employee that must be grossed up which further increases the financial impact
When drafting a termination agreement as an employer, please ensure that you can still claim any tax refunds following the TEQ agreements made in the past with the employee involved. This can be done by specifically addressing this in the settlement agreement.
8. Again TEQ: is severance pay also tax equalized?
Most employers would be of the view that a severance pay is out of scope from the TEQ agreement. Although this may be a common view, we have experienced in practice that employees (or their lawyers) can be very creative and argue that TEQ applies to any severance pay in case this is more beneficial to them. This can result in nasty discussions with the employee and can, depending the dynamics of termination of employment, cause the company more money than anticipated.
Although this would be exceptional, the same could also be true in the reversed situation where employers view (for example, supported by an assignment policy or letter confirming that TEQ applies) that TEQ in fact does apply to severance pay. The same discussions and ditto financial impact can arise due to a different view between parties.
Clarify whether TEQ applies on severance pay or not. It is best to already include this in an assignment policy as this will give least cause for a potential discussion. If such is not (yet) included in an assignment policy, it is recommendable to at least clarify such in the settlement agreement.
9. Termination due to sickness
In the Netherlands, based on Dutch social security, employers have to pay at least 70% of the last earned salary for two years for sick employees. This obviously is a harsh rule for employers, especially if such occurs and they have not covered such risk with an insurance agent. After this two year period, the employment is often terminated. When terminating someone’s employment who is sick there is another disadvantage for (larger) employers as such also has an impact on the differentiated employer social security premium for a period of 10 years (!) because the sickness / disability history is considered in the determination of the applicable differentiated premium. Meaning that the premium amount for a period of 10 years is higher than it would have been if the employee would not have been sick. Therefore, it is often agreed that the employee reports better before the termination date.
In cases of sickness, agree with the employee in the final settlement agreement that he or she reports better prior to the termination date (3).
The above makes clear that careful attention is required when terminating an employment contract of international employees in the broadest sense, such as 30% ruling holders, expats, commuters or just employees who consider leaving the country in view of their termination of employment. But also, the penalty taxes as well as the differentiated premium issue for sick employees have to be considered for both international employees as well as “normal” local employees. It goes without saying that proper tax and legal advice is best obtained when terminating employment contracts of, especially, international employees.
- An additional tax liability can just the same occur if the new country applies the exemption with progression method in which case the income has to reported in the new country whilst the country grants a tax treaty relief at the average tax rate. As such, a progression disadvantage occurs.
- For US resident with 30% ruling (and electing for partial non-residency) the Dutch tax liability on employment income is limited to Dutch workdays in the applicable reference period.
- Note that employees who report themselves sick again within 6 weeks after having reported better, the (larger) employer has the disadvantage that also in these cases the sickness / disability history of such employees are considered for a period of 10 years for differentiated premium purposes.