Australia: Taxation Of Employment Termination Payments

Terminating the employment of a person is never a happy occasion, but things can get worse if a dispute arises over the taxation of any payments to be made to the departing employee.

In July 2007, the system of taxing termination payments was changed. Under the new system, payments made in consequence of the termination of employment which are received within 12 months of termination are regarded as "Employment Termination Payments" (ETPs). Certain payments are, however, specifically excluded from this definition, and, it is these exclusions which are a common cause of dispute between the employer and the former employee.

In broad terms, ETPs are taxed as follows:

• tax free component includes any payments referable to employment prior to 1 July 1983 and any invalidity component;

• tax offset applies to payments up to a cap of $145,000 (for the 2008/09 income year - indexed annually) so that the tax rate is:

• the excess above the cap which is not tax free is taxed at the top marginal rate.

Each class of payment which is excluded from the ETP regime is, however, taxed differently. Payments for personal injury (including psychological damage or mental injury) are tax free. Payments in relation to genuine redundancies are taxed at concessional rates and unused annual leave or sick leave payments (unless they refer to periods pre-1993 or are in connection with genuine redundancy) are taxed at the normal marginal rates.

From the departing employee's point of view, it is important that any payment to be made by an employer is properly identified. For example, if an employee is paid a lump sum for personal injury (for loss of reputation or stress) and for unfair dismissal, and the amount is undissected, none of it will be regarded as a tax free personal injury payment. It would, in all likelihood, be taxed as an ETP.

In the current economic climate, it is probable that many terminations will be directly related to redundancy. For the tax concession to apply it is important that termination is, in fact, a genuine redundancy. In broad terms, a genuine redundancy payment is so much of a payment received by the employee who is "dismissed" from employment because his or her position is made "redundant" and that exceeds the amount that he or she would reasonably be expected to have received on a voluntary termination.

The term "dismissal" implies an involuntary termination (on the employee's part) instigated by the employer. However, it does include employees who may be asked whether they would accept a redundancy package as long as the decision to terminate is made solely by the employer.

In August 2008, the Australian Taxation Office (ATO) published a draft ruling on redundancy. In that draft ruling, the ATO indicated that "a job becomes redundant when an employer no longer desires to have it performed by anyone." A job is described as a collection of functions, duties and responsibilities.

A position is therefore made redundant when the functions, duties and responsibilities formally attached to a position are determined by the employer to be superfluous to its current needs and purposes, and the purposes of the organisation.

In describing a termination payment as a genuine redundancy payment, both the employer and employee must be careful that they are not simply using the term to facilitate a better tax position for the employee. Voluntary termination or termination as a result of poor performance can never be a redundancy.

While structuring a termination payment so that an individual has the best possible tax outcome is unlikely to be of much comfort to that individual, failing to do so will add to an already stressful situation and in all likelihood will end up in a dispute between the employer and former employee.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.