Businesses will often face the termination of an employee’s employment. There are a number of reasons this may happen—for example, via an amicable resignation or via a redundancy—and in many instances the employer will pay the exiting employee a termination package. This termination package can consist of various elements such as unused leave payouts, transfers of assets, golden handshakes and genuine redundancy payments.
Determining the tax consequences of such payments, including the associated pay as you go (PAYG) withholding obligation arising for the employer, is often an exercise more complex than the employer or employee may expect due to intricacies in the law.
A recent TaxEd webinar on this topic explored some of these issues, seeking to clarify how the tax rules work in relation to different elements of a termination payment. This article highlights and summarises various key issues and comments from the webinar.
From the perspective of the taxation of termination payments, ‘payment’ is taken to include more than cash provided to the employee—it also includes the market value of assets transferred to the employee, as well as payments made to third parties at the employee’s direction.
Where there is a transfer of an asset that could be subject to either the termination payment rules or the Fringe Benefits Tax rules, the termination payment rules take precedence.
Employment termination payments (ETPs)
A payment that is received by a taxpayer (in consequence of the termination of employment) no later than 12 months after termination will qualify as an ETP for tax purposes, unless specifically excluded from being an ETP.
There are two types of ETPS:
- If the payment is received by the employee, it is a life benefit ETP.
- If the payment is received by the employee’s deceased estate or beneficiary due to the employee’s death, it is a death benefit ETP.
ETPs receive concessional tax treatment where the payment does not exceed:
- the indexed ETP cap ($205,000), if the payment is an “excluded ETP” (a defined term that includes death benefit ETPs);
- the lower of the indexed ETP cap and the whole-of-income cap ($180,000 less the employee’s non-ETP related taxable income for the year), if the payment is a “non-excluded ETP”.
Any amount received in excess of the relevant cap is taxed at top marginal rate.
The maximum tax rate that can apply to an ETP that does not exceed the taxpayer’s relevant cap is affected by whether the person:
- has reached their preservation age – resulting in a maximum tax rate of 15% plus Medicare Levy; or
- has not reached their preservation age – resulting in a maximum tax rate of 30% plus Medicare Levy.
In relation to death benefit ETPs, the tax outcome is affected by whether or not the recipient is a death benefits dependant:
- Where the recipient is a death benefits dependant, the amount of the payment up to the ETP cap will be tax-free.
- Where the recipient is a non-death benefits dependant, the amount of the payment up to the ETP cap will be subject to tax at 30% plus the Medicare levy.
Genuine Redundancy Payments (GRPs)
A redundancy payment that meets specific criteria can qualify as a GRP for tax purposes and access tax-free treatment up to a certain calculated limit. However, not all redundancy payments are GRPs, so care needs to be taken regarding whether the criteria have actually been satisfied.
Where a redundancy payment is not a GRP, or exceeds the tax-free limit, the amount will be taxed under the ETP rules.
Key issues that are often missed include the following:
- Not only must the payment be for a genuine redundancy (i.e. the position, not the person, must be redundant), it must also exceed what the employee would have received on voluntary termination.
- If the employee is over 65 (or some earlier compulsory retirement age) at the time of the redundancy, the payment cannot qualify as a GRP.
- If the parties are not acting at arm’s length and the payment exceeds what could be expected to be paid under an arm’s length arrangement, then the entire payment cannot qualify as a GRP.
Unused annual leave and long service leave payments
Where unused annual leave and long service leave payments are paid in conjunction with a GRP or early retirement scheme (which is treated in the same manner as a GRP), then these types of payments can be subject to tax at a flat 32% rate, instead of at marginal rates.
Under previous incarnations of the termination payment rules, ETPs could either be taken as cash, or rolled directly into superannuation. This is no longer the case as employees must receive the payment as a lump sum. Accordingly, if the employee wishes to put the ETP monies into superannuation, they will first need to be taxed on the amount and then personally make a contribution into their superannuation fund (subject to their ability to do so under the requirements of the Superannuation Industry (Supervision) Act 1993).
While employees may wish to salary package their termination payment, the ATO’s general position is that this is not possible and that any attempt to do so will result in a non-effective salary package arrangement.
Where to from here?
As can be seen by the above summary, there are a number of intricacies and complexities that arise in relation to termination payments that can cause confusion and errors. Therefore, careful consideration of these rules is required to ensure that employers correctly meet their withholding obligations.
Editor’s note: Did you miss out on the webinar? Not to worry! All TaxEd webinars are recorded. Click here to purchase a copy of the recording (including the technical paper and slide pack).