Tax Deduction of Attorney's Fees in a Labor Dispute?

Judgment of the Supreme Court of 10 August 2007 (LJN: AZ4768) The accessibility of the legal system to employees has been at the center of attention for a long time already. In labor disputes it often happens that the employer compensates the attorney's fees (or part thereof) to the employee dismissed as part of a termination settlement. If the employer does not pay this compensation, the question arises whether the costs incurred by an employee personally in connection with a labor conflict with his employer, such as costs of litigation and of legal assistance, are tax-deductible. On 10 August 2007 the Dutch Supreme Court answered this question.

The Situation until 2001

Until 2001 employees could declare their attorney's fees to the Dutch Tax Department as deductible expenses made for the purpose of retaining income from labor. When the Income Tax Act 2001 (Wet op de inkomstenbelasting 2001, "Wet IB 2001") entered into force, this option was cancelled. Under the Wet IB 2001 employers can compensate the employee tax-free for attorney's fees incurred by the employee, while costs incurred by the employee personally are non-deductible.

The Facts

The case decided in August 2007 concerned an employee who had spent €5,877 in 2001 on proceedings against his employer due to a labor conflict. Through these proceedings the employee attempted to be reinstated (part-time) as an employee partially unfit for work. When making his tax return for the year 2001, the employee quoted the amount of €5,877 as negative income from previous employment. The Tax Inspector did not accept this and allowed him no other ground for deduction either, whereupon the employee took the position that he was the victim of unjustified discrimination by the legislator.

The Opinion of the Advocate General

The Advocate General ("AG") of the Supreme Court considered it to be manifestly disproportionate that in a labor conflict the costs of professional legal assistance are non-deductible, while the compensation of such costs is tax-free. The AG was of the opinion that the reason behind this unequal treatment - effective taxation - is not a ground that justifies unequal treatment. Furthermore, the AG is of the view that the legislator's position that it is up to the employer to compensate the costs of legal assistance cannot be regarded as a realistic position, and as such provides no justification for unequal treatment. The AG concluded that the Wet IB 2001 makes an unjustified distinction by allowing tax immunity for the compensation of legal assistance costs on the one hand, and excluding the deduction of such costs on the other hand.

The Supreme Court

The Supreme Court did not follow the AG's advice. The Supreme Court put first and foremost that when the Wet IB 2001 was debated in parliament, the proposal to include the exception of a tax allowance for costs of litigation and legal assistance incurred by an employee in connection with a labor conflict with his employer was discussed at length. However, parliament decided not to accept this proposal. The Supreme Court concludes from the history of this act that apparently it was the legislator's opinion that there was insufficient ground to infringe the structure of the (then) legislative proposal. The Supreme Court continued by stating that the legislator has ample freedom of evaluation when examining whether there is an objective and reasonable justification for unequal treatment. The Supreme Court added, without an explanation, that there was no reason to assume that the legislator's opinion was based on an unreasonable ground. Therefore, the Supreme Court maintained the legislator's opinion that the employee cannot deduct his attorney's fees.

What This Means in Practice

Despite the AG's opinion in favor of employees, we must conclude from the Supreme Court's judgment that before starting proceedings against his employer, an employee should take into account that his attorney's fees will not be tax-deductible, whereas his employer may compensate these costs tax-free. Therefore, an employee should try to negotiate that his employer will pay the attorney's fees directly as part of a termination settlement. The employer too has an interest in such a settlement, because it allows the employee to achieve a net result - the amount of the remaining severance pay, minus tax payable, minus attorney's fees payable - while leaving the employer to pay a smaller gross amount (since no tax is payable on the attorney's fees).