Tax allowance for legal expenses and taxation, if the employer pays the expenses

We have received a lot of questions in relation to the possibility of deducting legal expenses in connection with cases on payment of salary or other claims against the employer.

In 2001, the National Income Tax Tribunal (SKM2001.473.LSR) decided on the situations in which an employee has the right to deduct legal expenses. Prior to the case, a terminated employee had taken legal action against his employer, partly with a claim for compen-sation due to defects in the formalities in connection with the termination, partly with a claim for additional pay. Due to acquiescence, the employee’s claim was not sustained.

The National Income Tax Tribunal was to decide on the question of the deduction of the legal expenses, which the employee had paid. The National Income Tax Tribunal decided that an employee has the right to deduct legal expenses, if the expenses concerns income earned, which is to be included in the income statement, cf. Section 6 (2) (a) of the Central Government Tax Act. If the expenses solely concern capital transactions or capital space/source of income, the expenses are not deductible.

In this specific case, this meant that the employee did not have the right to deduct the part of the legal expenses that concerned the claim for compensation due to defects in the formalities in connection with the termination, as this was an injury-to-feelings-like compensation, which, according to previous decisions, would be exempt from tax. On the contrary, the claim for compensation for additional salary constituted ordinary taxable income, for which reason the part of the legal expenses that concerned this part of the claim, should be regarded as being tax-deductible, cf. Section 6 a of the Central Government Tax Act.

According to auditor Christian Rugholm Yde of Revision Limfjord, the above-mentioned can be translated as follows:
Does an employee have the right to deduct legal expenses in connection with a case against his employer?
”If the case concerns taxable back-payment of salary or similar, then the answer is yes. However, the allowance is only obtainable as an income tax relief with a tax value of 28 %. Furthermore, there is a threshold of DKK 5,900 (2017 numbers), which means that solely expenses exceeding the threshold are deductible.
If the case concerns a tax-exempt compensation for e.g. pain and suffering, the answer is no.
It is important that the attorney who provided the legal assistance, in his or her invoice clearly indicates the extent of the assistance and divides the fee in to a tax-deductible part and a non-deductible part.”

Taxation, if the employer pays the expenses:
It occurs that the employer, as part of a settlement out of court, accepts to pay the legal expenses of the employee. In which way is the employee subject to taxation in this relation?
”According to the Danish Tax Assessment Act, as a point of departure, any benefit provided by the employer is taxable, and in the same way, the point of departure is that the employer is subject to notification duty. Whether it is a question of an employee benefit or payment of a private expense for the employee, must be determined in each case. In this connection, the name on the invoice may be an issue. If nothing else is mentioned, the fair market value is subject to taxation, which means the actual expenditure.
The employer must report the expense in section 55, and the employee must enter the value in section 20 on his or her income-tax return. In general, amounts entered as income in section 20 may be deducted according to the same rules as mentioned above.”
The employer’s right to deduct payroll costs.

A related question is to which extent the employer has allowances. On 30 June 2017, the Supreme Court (U.2017.2960.H and U.2017.2979.H) decided on two cases, in which two banks were denied a deduction of payroll costs. The employees had been working with branch office acquisition, and according to the Central Tax Administration, the payroll costs were not deductible operating costs, but non-deductible capital costs. A deductible operating cost is used for acquiring taxable income, whilst a non-deductible capital cost is used for establishing a new income base, e.g. in the shape of starting or expanding a company. The Supreme Court reached the deci-sion that payroll costs cannot by definition be regarded as operating costs, and that a specific assessment was required as to whether the work performed concerned operation or capital. In the wake of the ruling, the government introduced a bill to ensure that compa-nies should be able to deduct payroll costs, regardless of the employee not working or only partly working with assignments relating to operations, and the access to deductions is now subject to Section 8N of the Danish Tax Assessment Act.

How ”income” is otherwise to be interpreted, cf. Section 6 of the Central Government Tax Act, was determined by the Supreme Court in the Symbion case (U.2012.647.H). The case concerned a venture company that invested in very new companies. The venture com-pany had paid a management fee to another company for it to administer the venture company and its investments. The question was whether the venture company had the right to deduct this cost. The Supreme Court determined that the term ”income” as stated in Section 6 of the Central Government Tax Act, was to be interpreted as the taxable income, in the way that expenses may be deducted from the taxable income as operating costs, if they are used for acquiring, securing and maintaining the taxable income.