The Constitutional Court finds Article 27 of the Income Tax Act incompatible with the Constitution of the Republic of Slovenia

On 29 September 2022, the Constitutional Court, in its judgment No U-I-26/20, found that Article 27(5) of the Income Tax Act (ZDoh-2) was incompatible with the Constitution of the Republic of Slovenia and ordered the National Assembly of the Republic of Slovenia to remedy the incompatibility within one year of the publication of the decision.

Article 27(5) of ZDoh-2 provides that compensation for damage resulting from personal injury, illness or death is exempt from income tax. However, the exemption does not explicitly include compensation for non-pecuniary damage resulting from the violation of personality rights, which, according to the petitioner, is not in line with the principle of tax justice and the principle of equal distribution of the tax burden, which, in the tax area, constitute an expression of the general principle of equality laid down in Article 14(2) of the Constitution of the Republic of Slovenia.

The Constitutional Court first examined whether it is true that compensation for non-pecuniary damage resulting from the violation of personality rights is not covered by Article 27 ZDoh-2, which lists the cases in which no income tax is payable on the compensation. In this respect, the Court considers that if the legislator chooses an exhaustive norm as the method of norming, all the cases which the legislator wished to regulate are deemed to be regulated. Consequently, the possibility of using analogy as a method of interpreting legal rules is excluded. Because of that, the case of compensation for non-pecuniary damage as a consequence of a violation of personality rights is excluded from the exemption from taxation.

Therefore, if the non-pecuniary damage is the result of personal injury, illness or death, the injured party is exempt from income tax on such compensation. However, if the damage was caused by some other circumstance (e.g. publication of an article), the injured party is liable to pay income tax on such compensation. ZDoh-2 therefore takes into account the cause of the damage as a criterion for (non-)taxability. The Constitutional Court found that such a distinction between the taxation of compensation on the basis of the cause of the damage is incompatible with the principle of equality laid down in Article 14(2) of the Constitution of the Republic of Slovenia.

The principle of equality does not mean that the legislator may not regulate identical situations differently, but it does require the legislator to have a reasonable and factually justified reason for doing so, having regard to the subject matter of the regulation and the objectives it seeks to achieve. In assessing whether there is a reasonable and factually justified ground for such a distinction in the particular case, the Constitutional Court primarily took into account the function of monetary compensation for non-pecuniary damage, which is to satisfy the injured party. It found that the effect of the payment of compensation on the economic situation of the injured party is the same irrespective of the source of the damage. In the light of the foregoing, the Constitutional Court concluded that in the present case there was no reasonable and factually justified reason why certain compensation payments should nevertheless be taxed, even though their purpose was the same. In so doing, the Constitutional Court rejected the Government’s submissions that such a distinction was justified, since personal injury, illness or death were objectively verifiable causes of the damage, which enabled the tax authority to control the tax exemptions and reduced the possibility of abuse. It explained that, where damages are awarded by a judicial decision, the court must, despite the principle of dispositive or discretionary nature of claims, take care not to recognise dispositions of the parties which are contrary to mandatory rules or moral rules. Consequently, it must also take care that the parties do not seek to achieve objectives contrary to the tax rules, thereby preventing possible abuses. However, in cases where compensation is paid on the basis of an out-of-court settlement, although the possibility of such control is indeed reduced and the possibility of abuse is consequently increased, this does not, in the opinion of the Constitutional Court, constitute such a compelling reason as to justify different treatment from the other forms of compensation. The tax authority has various mechanisms at its disposal to detect and prevent possible abuses. Specifically, on the question of the taxability of the compensation, the tax authority can and must verify that the out-of-court settlement was not concluded with abusive intent.

The National Assembly of the Republic of Slovenia has to remedy the inconsistency within one year after the publication of the decision. Until the inconsistency is remedied, the same rules apply to the taxation of compensation payments for all legally recognised forms of non-pecuniary damage as apply to the taxation of compensation payments as defined in Article 27(5) ZDoh-2.

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