Rules on the Treatment of Seniority Pay and Applicable Tax Exemptions

"People who believe a problem can be solved tend to get busy solving it." William Resperry

With enterprises considering how best to respond to the new labor pension system going into effect in July 2005, a much-discussed question recently has been whether seniority payments would still be considered retirement payments that could enjoy a fixed-amount tax exemption if such payments were made by cashing out employees' maintained seniority and issuing them lump-sum seniority settlement payments.

The Ministry of Finance initially was of the opinion that if an employee had not left his/her current employer, then any and all seniority payments received from the employer are subject to tax as salary income. They cannot be regarded as retirement benefits or enjoy a tax exemption of a fixed amount. That said, there are questions as to whether "leaving one's employer" might not include cashing out one's maintained seniority and "leaving" prior to being rehired. In addition, there is bound to be controversy over whether it is consistent with the aims of the Income Tax Act to regard seniority payments as salary and disallow a fixed tax exemption for them.

Before major revisions were made to the Income Tax Act in 1963, Category 3 salary income in Section 1, Article 14 of the Act included retirement payments. However, by law, 25% of such a payment was regarded as taxable income in the current year, and the remainder was divided over the following three years for taxation. After the major revisions, ‘retirement payments' was revised to read ‘pension payments'. If these were paid in one lump sum, then half of the amount would be taxable income in the current year. Many amendments to these regulations followed, but this rule was not changed.

In 1972, the pension payment portion of salary income was amended to apply only to pension payments made on a periodic, regular basis. The gist of the amendment clearly seems to be that a lump sum pension payment does not constitute salary income. This rule remained unchanged after numerous subsequent amendments of the law. Until it was amended in 1998, the Income Tax Act separated regular pension payments from salary income, with lump sum pension payments and severance pay, retirement payments, superannuation, etc., classed separately under Category 9 (retirement income).

According to the rules in the Labor Retirement Pension Act as it now stands, workers originally covered by the Labor Standards Law and who continue working for the same business after the Act takes effect may choose to continue to apply Labor Standards Law rules.
But when they leave and take employment elsewhere, they must apply the pension system under the Labor Pension Act. For those that choose to switch to the Labor Pension Act pension scheme, work seniority (years-in-service benefits) accumulated prior to the new scheme will be maintained. Under the said laws and regulations, should the employee's labor contract later terminate legally, the employer must calculate and give the maintained seniority pension or severance pay using the average salary at the close of the contract. As to the income nature of such pension or severance pay, there can be little doubt that it should be deemed to be within the scope of retirement pay under the Income Tax Act. However, suppose an employee and an employer both apply the Labor Pension Act, and by special agreement cash out the employee's maintained seniority in an amount not lower than the standard in the Labor Standards Law. Because the law is not clear, when it comes to applying it, it is far from certain whether, after all, such seniority settlement payments should be counted as salary income or retirement (termination) payments.

Looking at the ten categories of income stipulated in Section 1, Article 14 of the Income Tax Act, those that constitute remuneration for services are salary income, income from running a business, and retirement income. Of these, salary income is the form that income from labor services generally takes. Seniority settlement pay is compensation to workers for services provided, and where the worker does not retire or otherwise leave an employer in order to receive it, then classifying it as salary income seems reasonable enough. However, according to the legislative intent of the Labor Pension Act, seniority settlement pay should constitute an advance pension payment; its nature is thus virtually the same as a pension payment.

In the case where the employer and employee agree to cash out the former's seniority benefits, and the employer is rehired after leaving, the labor contract is terminated not in accordance with Labor Standards Law rules, but based on an understanding between the two parties, so the seniority settlement payment would seem not to be in the nature of a pension or retirement payment, according to that Law. Nonetheless, based on the underlying tax principle here, the income nature of seniority pay should have almost nothing to do with whether or not the labor contract is formally terminated, or whether or not one is rehired after leaving. So, for tax purposes, it would still seem proper to regard seniority settlement payments as being retirement income.

Bearing the above in mind, if seniority settlement payments are considered to be retirement income, then it goes without saying that that income is, by law, entitled to a fixed tax exemption.

If, however, seniority settlement payments are considered to belong to salary income, then it becomes questionable whether such income would enjoy tax exemption. Under Section 3, Article 14 of the Income Tax Act (i.e., "Category 10" income), one-half of variable income is untaxed. The purpose is simply to avoid having a taxpayer's tax bracket in the current year shoot up and cause an unwarranted rise in his/her tax burden. Looking at the literal meaning and legislative intent of the statute, the particular forms of variable income mentioned must be taken as illustrative and not as an exhaustive enumeration; a part of salary income that is variable in nature and which has not been excluded should also enjoy the 50% exemption. Consequently, even if seniority settlement payments are considered to be salary income, it would appear that the one-half tax exemption should still be allowed in order to avoid going against the "ability to pay" principle in taxation and the legislative intent of the Income Tax Act.

According to Income Tax Act rules, the retirement payment portion of total income may enjoy a tax exemption of a fixed amount. Salary income, on the other hand, must all be entered as taxable income, but income of a variable nature enjoys exemption on one-half the amount. After the new labor pension system takes effect, how seniority settlement payments are treated - as salary income or retirement payments - and whether that income is eligible for a fixed exemption or an exemption on one-half the amount, will have a truly huge impact on workers' tax positions. Extreme caution should be exercised when determining rules on the income nature of that income and the applicable tax exemption. Beyond the necessity to adhere to the letter of the tax law's clauses, one must also bear in mind the tax law's evolution and its aims, as well as the provisions of the Labor Standards Law and the Labor Pension Act. Otherwise, workers may end up being hurt by implementation of the new pension system even before they see any benefits.