Tax refund for loss of earnings loss subject to income tax
Tax refund for loss of earnings loss subject to income tax
If a taxpayer is no longer able to pursue gainful employment as a result of a damage event caused by a third party, he or she can receive so-called loss of earnings compensation in accordance with civil law standards. In its ruling of October 15, 2024 (case no. IX R 5/23), the German Federal Fiscal Court (BFH) had to clarify the legal question of whether the income tax to be paid for this and then reimbursed by the injuring party or its insurer is subject to income tax or a non-taxable reimbursement of expenses.
In the case in dispute, a non-self-employed taxpayer became unable to work due to a medical treatment error. She received compensation for her loss of earnings from the injuring party’s insurance company. According to the so-called net wage method, both the lost net earnings and later the income tax actually incurred on these were reimbursed. The tax office treated the payments as income from employment. The taxpayer argued against the taxation of the tax refunds on the grounds that this was not a compensation for lost income, but a tax loss, the compensation of which was not taxable. Both the tax court of Baden-Württemberg of first instance and the BFH agreed with the tax office’s view.
This is because if the injuring party or their insurer is obliged to compensate the injured party for their loss of earnings, the obligation to pay compensation also extends to the tax due on this. Under civil law, these are therefore two directly related items of a loss of earnings compensation. Under tax law, this means that not only the loss of net earnings paid, but also the tax burden reimbursed by the injuring party must be treated as taxable compensation. In this respect, there is no non-taxable reimbursement of expenses.
It is also not a case of compensation for genuine tax damage. This would require the damage to be avoidable. The BFH has assumed this, for example, in the case that an employer had to pay compensation to the employee for an excessive income tax assessment. This was justified by the fact that damages to be paid due to an excessive tax assessment serve to compensate for a financial loss that occurred in the private sphere rather than in the employment sphere. However, this legal principle is not transferable to compensation for loss of earnings. This is because by reimbursing the tax attributable to the damage, the injurer is not compensating the injured party for avoidable tax damage, but for the lawful tax consequence of compensating the (net) loss of earnings. An exemption of this tax refund would contradict the so-called gross wage method, which would result in the taxation of the total amount of compensation paid out in one go.
The BFH also confirmed the findings of the court of first instance with regard to reduced taxation in accordance with section 34 of the German Income Tax Act. On the one hand, this was ruled out as the loss of earnings compensation did not meet the required exceptional nature in the case decided. The insurance company did not reimburse the loss of earnings compensation in a lump sum, but rather in staggered payments over several assessment periods. Secondly, in the view of the BFH, the loss of earnings compensation does not constitute compensation for several years of work, as it was compensation for not carrying out an activity due to liability for damages under civil law.
In the case in dispute, a non-self-employed taxpayer became unable to work due to a medical treatment error. She received compensation for her loss of earnings from the injuring party’s insurance company. According to the so-called net wage method, both the lost net earnings and later the income tax actually incurred on these were reimbursed. The tax office treated the payments as income from employment. The taxpayer argued against the taxation of the tax refunds on the grounds that this was not a compensation for lost income, but a tax loss, the compensation of which was not taxable. Both the tax court of Baden-Württemberg of first instance and the BFH agreed with the tax office’s view.
This is because if the injuring party or their insurer is obliged to compensate the injured party for their loss of earnings, the obligation to pay compensation also extends to the tax due on this. Under civil law, these are therefore two directly related items of a loss of earnings compensation. Under tax law, this means that not only the loss of net earnings paid, but also the tax burden reimbursed by the injuring party must be treated as taxable compensation. In this respect, there is no non-taxable reimbursement of expenses.
It is also not a case of compensation for genuine tax damage. This would require the damage to be avoidable. The BFH has assumed this, for example, in the case that an employer had to pay compensation to the employee for an excessive income tax assessment. This was justified by the fact that damages to be paid due to an excessive tax assessment serve to compensate for a financial loss that occurred in the private sphere rather than in the employment sphere. However, this legal principle is not transferable to compensation for loss of earnings. This is because by reimbursing the tax attributable to the damage, the injurer is not compensating the injured party for avoidable tax damage, but for the lawful tax consequence of compensating the (net) loss of earnings. An exemption of this tax refund would contradict the so-called gross wage method, which would result in the taxation of the total amount of compensation paid out in one go.
The BFH also confirmed the findings of the court of first instance with regard to reduced taxation in accordance with section 34 of the German Income Tax Act. On the one hand, this was ruled out as the loss of earnings compensation did not meet the required exceptional nature in the case decided. The insurance company did not reimburse the loss of earnings compensation in a lump sum, but rather in staggered payments over several assessment periods. Secondly, in the view of the BFH, the loss of earnings compensation does not constitute compensation for several years of work, as it was compensation for not carrying out an activity due to liability for damages under civil law.
Notice: As a result, the income tax assessment of loss of earnings compensations under civil law should be carried out irrespective of whether the net or gross wage method is used as a basis. The benchmark for calculating damages according to the gross wage method is the lost gross earnings - i.e. including taxes and social security contributions - of the injured party. According to the net wage method, the damage to be compensated is calculated over a stretched period of time. The latter approach can therefore mean a higher administrative burden for both the claimant and the injured party, as the dispute case shows