When a Taiwan enterprise involved in negotiation, mediation, arbitration or litigation for disputes relating to tort, royalty payment, or other issues with a foreign company reaches a settlement with that foreign company and is required to make a settlement payment as compensation for damages, it is often controversial whether the settlement payment made to the foreign company is taxable income under Taiwan’s Income Tax Act.  In practice, taxpayers and tax authorities sometimes have different views on whether all of such settlement payment constitute compensation for damages; if so, such payment should not be subject to income tax or withholding tax.

Most tax authorities cite the ruling No. Tai-Tsai-Shui-Zi-831598107 issued by the Ministry of Finance on June 16, 1994 (the "Ruling") as the basis for taxation.  The Ruling provides:  “Where parties to a lawsuit reach settlement on the condition that one party withdraws the lawsuit in exchange for settlement payment, the portion of the settlement amount for compensating the other party’s damages is in the nature of damages compensation and not subject to income tax.  As for the portion which is not for compensating actual damages, it shall be considered as ‘other income’ as provided in Category 9, Paragraph 1 of Article 14 of the Income Tax Act and subject to income tax.”  According to this Ruling, a settlement payment would not be taxable if it is compensation for actual damages, while the parts of a settlement payment not directed to the compensation of damages are treated as “other income” and subject to income tax. 

The majority of the court decisions share the same view with the Ruling.  According to Article 216 of the Civil Code, damages compensation is limited to actual damage and loss of expected profits unless the law or contract provides otherwise.  As such, courts have held that since “actual loss” means the decrease of the value of an existing property caused by the damage, compensation for such damage does not increase the taxpayer’s property and is not treated as “income” under the Income Tax Act.  On the other hand, compensation for loss of expected profits would increase the taxpayer’s property and should therefore be treated as “income” under the Income Tax Act and subject to income tax.  If both parties fail to clearly itemize and specify the content of the settlement payment during the settlement process, the controversy as to whether such payment is to compensate “actual damage” or “loss of expected profits” is likely to arise.

Moreover, whether the settlement payment is “income” under the Income Tax Act is especially important for foreign enterprises.  That is because, according to the Ruling, compensation for loss of expected profits is treated as other income under the Income Tax Act which is more likely to be considered as income generated in Taiwan and subject to Taiwan’s income tax and should be withheld by the payer upon payment.

Based on the above, it is advisable that during settlement negotiations the parties clearly define the  items, content and amount of the part of the settlement payment that is to be directed toward compensation for damages.  It is also essential for the parties to collect and keep relevant evidence and documents to be able to adequately defend against challenges by the tax authorities, in order to avoid paying additional taxes or being penalized.