Taxation of severance payments in Germany could in the past create a lot of confusion for both employees and employers. Fortunately, there have been recent legal updates that simplify the process and provide benefits to both parties. This article breaks down the changes and how they affect employers and employees.
What was the severance pay process in Germany?
Also called Abfindung, severance pay is a financial compensation that employers offer to their employees when they terminate their employment. This happens as part of a mutual termination agreement or when there are layoffs due to the restructuring procedure. Severance pay offers employees a financial cushion during career transitions, but its taxation has traditionally been a challenging area.
Prior to the enactment of the new law, organisations applied Fünftelregelung (fifth rule) to calculate taxes. This law was intended to soften the financial blow that comes with high taxation by spreading taxes over a period of five years. At the time of severing payment, the employer pays just one-fifth of the tax due. This prevents employees from moving to a higher tax bracket.
Under the Fünftelregelung, the entire tax owed on the severance payment is not paid over five years. Instead, the tax is calculated as if the severance payment were spread over five years, but it is paid in full upfront when the severance is issued.
Severance payment process: What is changing?
The new law, called the Growth Opportunities Act (Wachstumschancengesetz) came into force in April 2024 and implements several changes in the taxation of severance payments, among other employment areas. Here are some of the significant changes.
Removal of Employer Responsibility in Applying Tax Laws
Under the previous regulation, employers were tasked with determining if the Fifth Rule was to be applied when making severance payments. If they find that the rules are applicable, they would spread the tax burden over five years but deduct the entire amount from the pay. Unfortunately, the process was prone to errors and miscalculations.
There have been cases where the Fifth Rule was applied and should not have been applied, only for the company to pay the difference in tax due. Other times, there were errors in computing tax and often put the burden on the business systems.
However, with the change in law, companies will not be required to determine if a tax cut should be applied to severance pay. Instead, they would compute payments as they would do with any other invoices. The law removes the responsibility from the shoulders of the employers.
Employees Will Be Required to Apply Tax Reductions Themselves
Under the old rule, employees had no responsibility when it came to determining what tax reliefs applied to their severance pay. It was the duty of the employer to find out, as explained above. However, with the new rules, they will be responsible for determining what tax reliefs can be applied to their termination pay and applying for them.
There are several tax reliefs that can be applied to the severance pay, depending on the situation of the employee. For example, if an employee receiving severance payment relocates for a new job, certain moving expenses can be deducted. Employees are also eligible for personal allowances if the severance payment is not significantly large.
The one-fifth rule to no longer apply for severance pay
The new law abolishes Fünftelregelung and does not provide a replacement. This means the one-fifth annual tax spread benefit has been removed and there is no suggested method to cushion the employees from moving to a higher tax bracket. Unless future regulations consider this, employees should look for any other relief if they want to pay lower taxes on high amounts that they get paid from the termination of their contracts.
Effects of severance pay changes on Employees and Employers?
The new tax laws have several implications for employees and employers alike. Employers will not be required to check what deductions can be applied to employee tax returns when making severance pay. This burden has been pushed to employees. The new law streamlines tax coverage when terminating job contracts for companies and lowers the risk that errors will be made when computing payments.
If you are an employee who faces contract termination after the enactment of the law, you need to check what tax reliefs can apply to your case and apply them in your next tax filing. Otherwise, you cease to enjoy the benefits of spreading tax over the five years. Since the tax laws can be quite confusing for most people, it is good to get a tax consultant when your contract is terminated.
Conclusion
Misunderstanding tax laws may have a lasting impact on your finances, especially if you are an employee facing a layoff. Therefore, it is important to seek legal advice in employment and tax laws. Specialist labour lawyers can aid you in navigating termination agreements to ensure you get the best deal. Here are some areas a lawyer can assist with:
- Optimise tax benefits from your severance pay. They will help you identify the tax reliefs that can be applied to your severance pay. This way, they help you optimise your tax benefits and reduce the amounts that you actually pay.
- Guidance on Severance Agreements: Sometimes job termination takes a toll on employees, and they are unable or do not know what to ask when making an agreement. A labour lawyer can help provide personalised advice so that you receive a pay that is worth the service you have rendered to the company.
- Review Severance Agreements: Experienced labour lawyers can check the severance payments to ensure that your rights are upheld. If the agreement obligates the employer to meet some responsibilities, such as health insurance or catering for housing for some time after severance, they can help enforce these clauses.
The new law dubbed the Growth Opportunities Act removes the benefits where severance payment tax deductions were spread over five years to prevent employees from moving to a higher tax benefit. It makes tax computation easy for employers but puts a burden on the employees losing their jobs. If your job gets terminated, you need to determine what reliefs may apply to lower your tax obligations. Our legal team can assist in getting you a favourable severance agreement and advice on reliefs to apply.
