Taxation of redundancy payments
The global financial crisis has seen many businesses undertake restructuring in order to weather against the financial storm. The issue of the subsequent retrenchment of employees has been at the centre of much political and media scrutiny of late. This article will provide a high level overview of two types of employment termination payments (ETP), ‘a life benefit termination payment’ and a ‘genuine redundancy payment’.
What is a ‘life benefit termination payment’?
If an employee’s employment is terminated for any reason other than death, the ETP is referred to as a ‘life benefit termination payment’. Generally, the ETP is to be received no later than 12 months after termination of employment – although some exceptions exist, such as genuine redundancy payments. The ETP ‘12 month payment rule’ is to prevent people abusing concessional tax rates by making payments over a number of income years.
Some payments received by employees on termination are not considered to be ETP's, including payments for accrued annual leave, unused long service leave and the tax-free portion of a genuine redundancy payment or early retirement scheme.
What is the tax treatment of an ETP?
An ETP comprises both a tax free component and a taxable component. The tax free component includes any 'invalidity segment' of the component and the 'pre-July 83 segment'. The taxable component is the whole payment less any tax free component.
The tax which is payable on an ETP depends on the terminated employee’s age. If the terminated employee has reached preservation age in the applicable income year, a taxation rate of 15% within the ETP cap applies. On the other hand, if the employee is below his or her preservation age in the applicable income year, taxation of 30% on the amount within the ETP cap is payable. A Medicare levy of 1.5% is also added to the listed tax rates.
The ETP cap is indexed every year. In the financial year 2009/10 the ETP cap is $150,000. Keep in mind that the ETP amount is reduced by any previous termination payments received in relation to the same termination.
It is no longer possible to roll over an ETP into a superannuation fund, except in very limited circumstances.
Certain employees may be entitled to have their ETP assessed using transitional tax rules, which can enable more favourable tax treatment of the payment. There are only limited circumstances which enable the transitional tax rules to apply and each of the following factors must be met:
- the payment must have been received on or after 1 July 2007 and before 1 July 2012; and
- the payments must have been received under an employment contract, instrument or agreement and must have been in force before 10 May 2006; and
- the employment contract, instrument or agreement must specify the amount of the payment, or a way to calculate a specific amount of the payment.
Employees must be careful when assessing whether an ETP payment falls within the transitional rules and note that any agreement entered into after 10 May 2006 is not transitional, even if the terms under which the payments are made are the same as any agreements or contracts that were in place prior to 10 May 2006.
What is a genuine redundancy payment?
From the perspective of the Australian Taxation Office, genuine redundancy payment is an amount received by an employee who is dismissed because the position of the employee is no longer required due to changes in the operational requirements of the employer’s business. The payment must exceed the amount that could reasonably be expected to be received by the employee in consequence of the voluntary termination of his or her employment.
It is important for employers to make sure that they can comply with the requirements for demonstrating a genuine redundancy, so that any subsequent severance payment is not considered a ‘sham’ by the Australian Taxation Office.
What is the taxation treatment of a genuine redundancy payment?
A genuine redundancy payment comprises a tax free amount and an assessable amount. The taxation of the tax free amount of a severance payment is calculated using the following formula:
Base amount + (service amount x years of service)
For the financial year of 2009/10 the base amount to be relied upon was $7,732 and the service amount $3,867. These amounts are indexed annually. The assessable amount is treated as an ETP.
What is the taxation treatment of payments for unused annual leave and unused long service leave upon termination of employment?
A payment made upon termination of employment for unused annual leave is taxed at the employee’s marginal tax rate, unless:
- any component of that payment relates to service before 18 August 1993; or
- the payment is made in conjunction with a genuine redundancy payment; or
- the payment is made for an early retirement scheme payment; or
- the payment relates to an invalidity segment of an ETP.
If any of these scenarios exist, an offset will apply so that the relevant taxation rate is 31.5%.
For unused long service leave, the applicable taxation rate depends upon the period of employment to which the payment is attributable. Certain periods of employment receive concessional tax treatment. Other periods receive a rebate if the payment is made in connection with a genuine redundancy payment, early retirement scheme payment or invalidity segment of an ETP.
There are a number of pitfalls for the inexperienced employer and employee in the taxation treatment of termination payments. particularly as the treatment of ETP's and redundancy payments is a specialised, technical area of taxation law. It is important that all background facts are considered in order to determine the appropriate taxation treatment of the relevant termination payment.
Peta Tumpey, Partner