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Payroll – Withholding on redundancy payments: Not as simple as it seems

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Employers may decide to terminate an employee’s employment for a variety of reasons. To the extent the termination results from the employer determining that the role/employee is no longer required, the employer may offer a termination or redundancy package to the employee. Often, these packages are more generous than those that would be paid if the employee had simply resigned.

From a taxation perspective, the payment of such packages results in various taxation obligations arising for the employer across the different employment tax regimes (e.g. Pay-As-You-Go Withholding, superannuation, Payroll Tax etc.). This article focuses on the Pay-As-You-Go Withholding (PAYG Withholding) obligations arising from the payment of termination/redundancy packages and some of the complexities that can be easily missed by employers.

Overview

Generally, termination/redundancy packages are lump sum payments comprised of various components, such as:

  • unused annual leave and unused long service leave amounts;
  • gratuity or ex gratia payments;
  • payments in lieu of notice;
  • severance pay;
  • unused sick leave;
  • etc.

These payments are generally included in an employee’s assessable income, with a PAYG Withholding obligation arising for the employer, similar to that applicable to ordinary salary and wages.

The taxation treatment of termination/redundancy payments is guided by Divisions 80 to 83 of the ITAA 1997. The provisions also inform the employer’s PAYG Withholding obligation.

Generally, these provisions separately identify and apply a concessionary rate of taxation to amounts that qualify as ‘employment termination payments’ (ETPs), unused annual leave payments and long service leave payments. However, this concessional treatment is generally only applied up to a specific limit or ‘cap’, with the balance taxed at the top marginal rate.

Additionally, where part of a payment qualifies as a ‘genuine redundancy payment’, a portion may be treated as tax-free.

Accordingly, employers paying termination/redundancy packages need to consider the following when determining their withholding obligation:

  • the extent to which the payment qualifies as a genuine redundancy payment, ETP or leave payment (as defined);
  • whether any portion of the payment will be tax-free;
  • the application of the caps.

Depending on the components of the payment, this process may be relatively straightforward. However, there are a number issues that are often overlooked by employers. The comments below cover some of the more common issues and are not intended to be a comprehensive list.

‘Payments’

Under the termination payment and withholding provisions, an employer’s obligation arises in relation to the total ‘payment’ made. Accordingly, a question arises regarding what constitutes a ‘payment’ for these purposes.

The answer is that ‘payment’ includes not only cash payments, but also the market value of any property transferred to the employee and any payments made by the employer to third parties at the employee’s direction.

For example, if an employee’s termination package includes a $150,000 cash payment and a car worth $40,000, the total ‘payment’ to be considered is $190,000.

Accordingly, employers need to ensure that they withhold an amount referable to not only the cash portion of a termination/redundancy package, but also to the value of property which is transferred and in relation to indirect payments made.

 ‘Genuine redundancy payments’

Employers will often refer to termination packages as ‘redundancy’ packages.

However, this does not automatically mean that the payment will qualify as a ‘genuine redundancy payment’ for taxation purposes. This is a key distinction because the correct categorisation affects whether a portion of the payment can be treated as tax-free, as well as how the caps apply (discussed further below).

For a payment to qualify as a ‘genuine redundancy payment’, a number of requirements must be satisfied.

The one that employers generally focus on is whether the redundancy is a ‘genuine redundancy’. In essence, this requires the position (rather than the staff member) to no longer be required by the employer. This issue has received substantial attention from the Commissioner of Taxation, and his views are outlined in Taxation Ruling TR 2009/2. Accordingly, this issue is not considered further.

However, employers often overlook the requirement that the amount paid must also 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 at the time of the dismissal’.

Accordingly, if the employee is entitled to an amount regardless of whether they resign or are made redundant, the amount will not qualify as a genuine redundancy payment for these purposes. In these circumstances, the amount cannot be treated as tax-free, and will be taxed as an ETP.

For example, if under the employee’s contract, they are entitled to severance payment equal to two week’s pay regardless of the method of termination, this portion of their redundancy package cannot qualify as a genuine redundancy payment for tax purposes and will be taxed as an ETP.

ETP concessional treatment and the caps

As outlined above, the concessional treatment of ETPs is restricted to the amount of the cap, with the excess taxed at top marginal rate.

The application of the cap is often an area of consternation and frustration for employers as there are two caps – the ‘ETP cap’ (refer s. 82-10(4)(a) and (b) ITAA 97) and the ‘whole-of-income cap’ (s. 82-10(4)(c)) – and it is not always clear which one is to be used.

The ETP cap is a set amount that is indexed ($205,000 for the 2019 income year), adjusted for any ETPs paid earlier in the same income year (s. 82-10(4)(a) or, as the case may be, by any ETPs paid for the same termination (s. 82-10(4)(b)).

The whole-of-income cap is equal to $180,000 (unindexed) less certain taxable payments received by the employee in the same income year (including unused leave payments paid on termination). However, the amount of the ETP to which the cap is to be applied is not included in the calculation of the cap.

For example, assume an employee received the following during the year:

  • $40,000 of salary;
  • $5,000 bonus;
  • $30,000 of unused annual and long service leave on termination;
  • $115,000 ETP representing a severance payment that did not qualify as a genuine redundancy payment or any other type of ETP subject to s. 82-10(6) (refer below).

In this instance, the employee’s whole-of-income cap would be $180,000 – $40,000 – $5,000 – $30,000 = $105,000.

The applicable cap is determined by reference to the type of ETP paid:

  • ‘Excluded’ ETPs, such as the taxable portion of a genuine redundancy payment (and certain other payments also listed in s. 82-10(6) ITAA 1997), are only subject to the ETP cap.
  • ‘Non-excluded’ ETPs, vis. payments which are not listed in s. 82-10(6), are subject to the lesser of (i) the ETP cap/reduced ETP cap and (ii) the whole-of-income cap. Generally, the whole-of-income cap will be lower. An example of a payment which is not listed in s. 82-10(6) would be a severance payment that would have been paid even if the employee had resigned (i.e. cannot qualify as a genuine redundancy payment) and is not made as a consequence of a dispute or for personal injury.

Note, as mentioned above, unused annual and long service leave payments are not ETPs and, therefore, the above caps have no application in relation to this portion of the payment. Instead, such unused leave payments are subject to taxation/withholding under Subdivisions 83-A and 83-B ITAA97.

Applying the above in relation to the prior example, the employee received an ETP of $115,000 plus $30,000 of unused leave on termination.

Withholding on the unused leave amount would be calculated pursuant to Subdivisions 83-A and 83-B ITAA97.

In calculating the amount of withholding on the ETP, as the amount is neither a genuine redundancy payment nor other listed payment, it would be a non-excluded ETP and the lower of the ETP cap and whole-of-income cap would apply.

As determined above, the employee’s whole-of-income cap would be $105,000, which is lower than their ETP cap of $205,000 (assuming the employee did not receive any other ETP in the income year or a prior income year). Therefore, the former is the relevant cap to apply.

Applying the cap, $105,000 of the ETP will be taxed at the concessional rate, with the remaining $10,000 taxed at top marginal rate. This amount of ‘tax’ is the amount to be withheld by the employer in relation to the ETP.

If the above was not sufficiently complex, additional complications arise where a single ETP with excluded and non-excluded payments is paid (in which case special ordering and calculation rules apply and employers will be required to issue two ETP payment summaries).

Accordingly, applying the caps can be confusing and employers will need to take care when determining their withholding obligations.

The employee’s age

Another factor employers need to consider is the employee’s age. This is important for a couple of key reasons.

Firstly, if the employee is aged 65 or over at the time of dismissal, the payment will not qualify as a genuine redundancy payment, despite meeting all the other requirements. Accordingly, the payment will be taxed as an ETP. A lower age may apply in some cases, such as where the employee’s employment could be terminated at that lower age.

Secondly, if the employee is aged above their preservation age at the time of the payment, then a lower concessional tax rate may apply to the ETP.

Accordingly, when calculating the withholding amount, employers must consider how the employee’s age will impact the calculation.

12-month rule

The concessional treatment for ETPs is restricted to amounts paid within 12-months of the employee’s employment being terminated.

For most employers, termination/redundancy packages will be paid out in entirety shortly after termination, and this rule will not need to be considered.

However, to the extent that all or part of the ETP is paid outside of the 12-month period, then the concessional treatment cannot be accessed and the payments will be taxed at the employee’s marginal rates (with corresponding withholding rates for the employer).

While this issue will rarely arise, it is something of which employers should be aware.

Conclusion

The rules regarding the taxation of termination/redundancy payments, which also inform the employer’s PAYG Withholding obligation, can be more complex than they initially appear and can negatively affect the net package received by the employee in unintended ways.

Accordingly, employers should carefully consider the rules and ensure that they understand all the potential traps and complexities that can arise.

Editor’s note: If you are looking for assistance in relation to preparing or reviewing ETP calculations, please do not hesitate to contact TaxEd – we would be pleased to help.

Disclaimer: This article is based upon information available as at the time of publishing and may be subject to change.