The Polish tax system contains many provisions on the taxation of different types of income, and one of the most complicated issues is the taxation of compensation (odszkodowania). Many people wrongly assume that any payment called compensation is automatically exempt from tax. The reality is much more complex, and the tax authorities and administrative courts consistently examine the actual nature of the payments received.
Exemptions of compensation from personal income tax require a detailed analysis not only of the name of the payment, but above all of its economic and legal substance. Case law of the administrative courts, in particular the NSA (Supreme Administrative Court), provides valuable guidance on the correct classification of different types of compensation.
Simply calling a payment compensation does not settle whether it is exempt from personal income tax. What matters is the actual nature of the payment and the legal basis on which it is paid, as confirmed by NSA case law
Legal basis for exempting compensation from tax
The rules on exempting compensation from personal income tax are found in Article 21 section 1 of the PIT Act (personal income tax). The basic exemption (point 3) covers compensation and redress (zadośćuczynienie) whose amount or calculation rules follow directly from the provisions of separate acts (or implementing regulations), as well as from collective labour agreements, work regulations and statutes. Under Article 21 section 1 point 3b, other compensation or redress received under a court judgment or court settlement, up to the amount specified in that judgment or settlement, is also exempt, but this provision contains important limitations.
The exemption in point 3b does not cover compensation for benefits the taxpayer could have obtained had the damage not been caused, nor compensation received in connection with a business. The category of lost benefits is particularly problematic in practice, because it often concerns situations involving the loss of earning capacity or other economic benefits.
The exemption in Article 21 section 1 point 3 does not apply, among other things, to severance payments and compensation for shortening the notice period, compensation under a non-compete clause, compensation for damage to business assets, or compensation resulting from contracts or settlements other than court settlements (exceptions in letters a–g)
Another important limitation concerns compensation resulting from contracts. In practice, this means that if compensation results solely from contractual terms or from an out-of-court settlement, it will not qualify for the exemption in point 3 (letter g). Compensation for damage to assets used in a business is excluded both from the exemption in point 3 (letter e) and from point 3b (letter a).
However, compensation from out-of-court settlements may be exempt on another basis – for example, amounts received under property and personal insurance are free from tax regardless of the form of settlement with the insurer (Article 21 section 1 point 4), except compensation relating to business assets. Compensation annuities under the Civil Code (Kodeks cywilny) granted for bodily injury or health disorder are also exempt, among others (point 3c).
Analysis of NSA case law
NSA case law provides valuable guidance on interpreting the rules on exempting compensation from tax. The judgment of 26 March 2024, case no. II FSK 832/21, is an example of the court's consistent approach of examining the actual nature of payments called compensation.
In that case, an employee received a payment from a former employer under a court settlement, which was called compensation. However, having analysed the circumstances, the NSA held that it was in fact remuneration for work (employment income), not redress for damage caused, so the exemption in Article 21 section 1 point 3b did not apply.
In its judgment of 26 March 2024, the NSA stressed that calling a payment compensation does not automatically mean it is exempt from tax. The court examines the actual nature of the payment, not just its formal name in the documents
The key point in this ruling was the finding that the disputed payment made by the employer was in the nature of remuneration for work, not redress for loss suffered. The court noted that the court settlement concerned payment of overtime pay, which meant that the payment was in fact remuneration due for work.
The Director of the National Tax Information (KIS), in a tax ruling issued at the request of the company as payer, and the administrative courts of both instances unanimously held that the payment was de facto remuneration for work, not compensation for damage, and was therefore subject to personal income tax.
Detailed analysis of the court case
The case heard by the NSA concerned a company that employed a worker under an employment contract in a task-based working-time system, without recording working time. This system created particular problems in settling working time and overtime pay. Similar overtime questions arise with the working time of managers.
During the summer season, the employee received additional overtime pay as a lump sum. The employee sued for overtime pay, claiming that the lump sums received did not reflect the actual amount of overtime worked.
In a task-based working-time system where working time is not recorded, it can be particularly difficult to establish the actual amount of overtime. That is why disputes about overtime pay in such a system are common
The parties terminated the employment contract by mutual agreement and concluded a court settlement providing for payment of a certain amount as compensation. However, the tax authorities and the administrative courts were not misled by the formal name of the payment and examined its actual economic nature.
The decisive finding was that the court settlement did not refer to any provision setting compensation, and the amount paid replaced the remuneration the employee could have received had the employment relationship continued. This meant that the payment was in the nature of remuneration for work (Article 12 section 1 of the PIT Act), not compensation for damage caused.
Practical tips for businesses
Businesses that make various payments to employees or other persons should analyse the legal nature of these payments particularly carefully. The key is to determine correctly whether a given payment is genuinely compensatory or is another type of taxable payment.
The first step should be to determine the actual nature of the payment. You need to examine whether the payment is genuinely redress for damage caused, or whether it is remuneration for work, a premium, a bonus or another type of income-type payment.
Businesses must analyse the nature of the payments they make carefully, because incorrect classification can lead to problems with the tax authorities. It is particularly important to distinguish between compensation and remuneration for work
Another important element is establishing the legal basis for paying the compensation: a statutory provision setting its amount or calculation rules, a court judgment or court settlement, an insurance contract, or perhaps just a contract or an out-of-court settlement. Compensation paid by a business solely under a contract or an out-of-court settlement is, as a rule, not exempt from tax (Article 21 section 1 point 3 letter g).
Detailed documentation of the circumstances in which the damage arose and its connection with the employer's business is also essential. This documentation should clearly show that the payment is redress for specific, documented damage.
Types of taxable compensation
The PIT Act specifies several categories of compensation that are subject to personal income tax despite the general exemption. The first group consists of severance payments and compensation for shortening the notice period of an employment contract specified in labour law, and severance payments made on redundancies for reasons not attributable to employees (Article 21 section 1 point 3 letters a and b).
| Type of compensation | Tax status | Provision | Notes |
|---|---|---|---|
| For shortening the notice period, severance pay | Taxable | Article 21 section 1 point 3 letters a–b | Employment income |
| For damage to private property | Exempt as a rule | Article 21 section 1 points 3, 3b, 4 | Business assets – taxable |
| For damage to health, redress | Exempt as a rule | Article 21 section 1 points 3, 3b, 3c, 4 | Judgment, court settlement, statute or insurance |
| For lost benefits | Taxable | Article 21 section 1 point 3b letter b | Also contractual compensation (point 3 letter g) |
Severance payments and compensation for shortening the notice period are subject to personal income tax as employment income – the employer withholds a tax advance on them. Compensation under a non-compete clause is also excluded from the exemption (letter d).
The second category is compensation for damage to property. Where it concerns private property and is paid by an insurer (point 4), under a court judgment or court settlement (point 3b), or in an amount following directly from a statute (point 3), it is free from tax. By contrast, compensation for damage to assets used in a business is taxable (point 3 letter e, point 3b letter a, point 4 letter a).
Compensation for damage to private property is, as a rule, free from tax if it is based on a statute, a court judgment or court settlement, or insurance. The key is to document the basis of the payment properly
The third group consists of compensation and redress for damage to health. The Act provides no limit here and no reduction by treatment costs – they are fully exempt if based on a statute (point 3), a court judgment or court settlement (point 3b, up to the amount specified in it), or insurance (point 4). Compensation annuities under the Civil Code are also exempt (point 3c).
The last category is compensation for lost benefits, which is, as a rule, subject to personal income tax – the exemption in point 3b expressly does not cover it (letter b).
Compensation exempt from income tax
Although many types of compensation are taxable, there are also categories of compensation that may be exempt. The first group consists of compensation and redress whose amount or calculation rules follow directly from the provisions of separate acts or from collective labour agreements, work regulations or statutes (Article 21 section 1 point 3) – with the exceptions listed in letters a–g.
This means that what decides the exemption is whether a provision itself sets the amount of compensation or the method of calculating it. Compensation agreed solely in a contract or an out-of-court settlement does not qualify for this exemption, even if it is called compensation.
Compensation for personal injury (damage to health, redress for harm suffered) is fully free from tax if received under a statutory provision, a court judgment or court settlement (up to the amount specified in it), or from insurance. The Act sets no amount limit
The second category is other compensation or redress received under a court judgment or court settlement, up to the amount specified in that judgment or settlement (Article 21 section 1 point 3b) – except compensation related to a business and compensation for lost benefits.
The third group consists of amounts received under property and personal insurance (Article 21 section 1 point 4), except compensation for damage to assets used in a business or in special branches of agricultural production.
The last category is special compensation, including compensation annuities granted under the Civil Code for bodily injury, health disorder or the death of a breadwinner (point 3c), compensation under geological and mining law (point 3d) and compensation for persons repressed for their activity for Poland's independence (point 3a).
Procedure for establishing the nature of compensation
Establishing the nature of compensation correctly requires a detailed legal and factual analysis. The first stage is to examine the legal basis for paying the compensation – whether it is a court judgment, a court settlement or another legal basis.
The next step is to analyse the circumstances in which the damage arose and establish whether damage requiring redress was actually caused. It is also crucial to establish the causal link between the event and the resulting damage.
- Examining the legal basis for paying the compensation
- Analysing the circumstances in which the damage arose
- Establishing the causal link
- Determining the economic nature of the payment
- Checking compliance with the rules on tax exemptions
- Preparing the appropriate documentation
The third stage is to determine the economic nature of the payment – whether it is genuinely redress for damage caused, or whether it has another nature, e.g. remuneration for work, a premium, a bonus or another income-type payment.
The procedure for establishing the nature of compensation requires a detailed legal and factual analysis. The key is to examine the legal basis of the payment and its actual economic nature
The fourth stage is checking compliance with the rules on tax exemptions. You need to check whether the compensation meets all the conditions set out in the PIT Act for the tax exemption to apply.
The final stage is preparing the appropriate documentation, which will be the basis for correct tax settlement. This documentation should contain all the necessary information and evidence confirming the nature of the payment made.
Tax rulings on compensation
Tax rulings issued by the tax authorities play a key role in tax practice relating to compensation. The Director of KIS regularly issues individual tax rulings (interpretacje indywidualne), which provide valuable guidance on classifying different types of compensation.
An example is compensation for terminating a lease early. Despite its name, an amount that makes up for rent the landlord will not receive is in substance compensation for lost benefits.
Compensation for terminating a lease early that makes up for lost rent relates to lost benefits – it is not covered by the exemption in Article 21 section 1 point 3b (letter b) and, where it results solely from the contract or an out-of-court settlement, not by the exemption in point 3 either (letter g)
In such cases, what matters is not the name of the payment but its actual economic nature. Compensation for terminating a lease early is compensation for benefits the taxpayer could have obtained had the lease not been terminated.
Tax rulings are particularly important where the law does not give a clear answer about the tax nature of a given payment. An individual tax ruling protects the applicant who follows it (Article 14k of the Tax Ordinance Act, Ordynacja podatkowa), which increases certainty about how to settle the tax on a specific payment of compensation.
Special cases in the taxation of compensation
Tax practice shows that there are special cases where compensation may be complex, combining different elements. An example is compensation for personal injury, such as road accidents, which often covers both redress for material losses and redress for harm suffered.
In such cases, each part of the payment is assessed separately. Redress for harm suffered and compensation for personal injury or damage to private property are, as a rule, free from tax (under a judgment, court settlement, statute or insurance), while the part that makes up for lost earnings or other benefits may be taxable.
For complex compensation, e.g. for road accidents, each part of the payment is assessed separately. Redress for harm suffered is, as a rule, exempt, while compensation for lost benefits under a judgment or court settlement is not
Another special case is compensation paid by insurance companies. Amounts received under property and personal insurance are free from tax (Article 21 section 1 point 4), except compensation for damage to assets used in a business or in special branches of agricultural production, and income from investment-type insurance (Article 24 sections 15 and 15a).
Compensation related to a business also requires particular attention. Under the PIT Act, compensation for damage arising in connection with a business is not exempt from tax.
The importance of precise wording and documentation
Precise wording in legal and accounting documents is crucial for the correct tax classification of payments. Calling a payment compensation without specifying its nature precisely can lead to misunderstandings and disputes with the tax authorities.
In business practice, it is worth seeking advice from tax law specialists to avoid errors in classifying payments. It is particularly important to prepare the documentation relating to compensation payments properly; it should clearly set out the legal basis, the circumstances in which the damage arose and the nature of the payment.
- The documentation must clearly set out the legal basis for paying the compensation
- The circumstances in which the damage arose must be described in detail
- The causal link must be documented
- The documents should precisely specify the nature of the payment
- It is worth keeping copies of all documents relating to the matter
The documentation should also contain information on the amount of the damage, how it was calculated and the method used to set the amount of compensation. All these elements may matter in the event of a tax audit or a dispute with the tax authorities.
Proper documentation of compensation should contain information on the legal basis, the circumstances in which the damage arose, the amount of the damage and how the compensation was calculated. This can be crucial in the event of a tax audit
Consequences of misclassifying compensation
Misclassifying compensation can lead to serious tax consequences both for the payer and for the recipient of the payment. If compensation is wrongly treated as exempt from tax when it is in fact taxable, this may result in a tax arrear being assessed together with default interest.
The tax authorities have the right to carry out a tax audit to verify whether compensation has been classified correctly. If irregularities are found, the taxpayer may be charged additional tax and default interest and, in the case of a fiscal offence or petty fiscal offence, may also face liability under the Fiscal Penal Code.
A manufacturing company paid an employee PLN 50,000 in compensation for an accident at work under a court settlement. Initially the whole amount was treated as exempt from tax. However, a tax audit found that PLN 20,000 was compensation for lost earnings, which was taxable (Article 21 section 1 point 3b letter b). The company had to pay the tax with interest.
Correct withholding of tax is particularly important for compensation paid by employers. If an employer wrongly fails to withhold tax on compensation that is in fact taxable, it may be held liable for that tax. We prepare tax office filings, including withholding agent returns, for clients of our accounting firm in Warsaw.
If you are unsure about the tax classification of compensation, it is worth applying for a tax ruling. It allows you to obtain the tax authority's position on how a specific payment is taxed, which protects the applicant who follows it.
