The taxation of employment termination payments

An employment termination payment (ETP) is generally a lump sum amount paid to an employee upon termination of their employment.Depending on the type of ETP, the employee’s age and years of service, the amount may be taxed in a number of different ways. An ETP may comprise of a tax-free portion, concessionally taxed portion and taxed portion.

In order for an ETP to be eligible for certain concessions, the employer must make a payment to the employee within 12 months of termination.  Otherwise, the entire amount will be included in the employee’s assessable income and taxed at marginal rates.

ETPs can include the following types of transactions:

  • a gratuity or “golden handshake”
  • payment in lieu of notice
  • compensation for loss of job
  • compensation for wrongful dismissal
  • payments for genuine redundancy or under an early retirement scheme
  • unused rostered days off, or
  • unused sick leave.

The extent of any concessional treatment will depend on the nature of the ETP paid – see below for discussion.

A common mistake employers make is including other payments made on or around the employee’s termination as components of the ETP.These include:

  • payments for unused annual leave or leave loading
  • payments for unused long service leave
  • salary, wages, allowances, bonuses and incentives the employer owes the employee for work done or leave already taken
  • compensation for personal injury
  • payment for a restraint of trade
  • foreign termination payments
  • employee share scheme payments
  • an advance or loan.

The aforementioned items are generally taxed as per the employee’s normal payroll and do not form part of the actual ETP.

Note that there are concessional treatments available for certain types of lump sum payments made on termination, including the lump sum amounts for unused leave entitlements, with provisions on the PAYG Payment Summary (individual-non business) specifically for the disclosure of these payments.

Taxing ETPS: caps on certain aspects

The taxable components of an ETP will be subject to concessional rates up to certain caps. There are two caps that you need to be aware of when you are calculating the tax on an ETP.

ETP cap

For the 2014-15 financial year, the ETP cap is $185,000, and for 2015-16 it is $195,000. This cap is indexed annually.

The ETP cap specifically applies to “excluded” ETPs, which include:

  • early retirement scheme (over tax-free limit)
  • genuine redundancy (over tax-free limit), and

Whole-of-income cap

The whole-of-income cap has been set at $180,000 since its introduction, and it is not indexed. The cap is reduced by any other taxable income earned in the income tax year either before or after receiving the ETP.

The whole-of-income cap only applies to non-excluded ETPs, which include:

  • non-genuine redundancy payments
  • golden handshakes
  • payment for rostered days off
  • payment for unused sick leave, and

For non-excluded ETPs, the lower of the caps (ie. ETP cap or whole-of-income cap) is applied. Given that the ETP cap is now $185,000 and soon to be $195,000, practically speaking the whole-of-income cap will always work out to be the lower cap applied.

Are ETPs subject to superannuation guarantee?

Determining whether an ETP is subject to superannuation guarantee (SG) depends on looking at the type/purpose of the ETP.

As SG is based on “ordinary times earnings” (OTE), the character of the termination payment is important. For example, if an ETP was paid in lieu of notice, that would be OTE as it would have been an amount that the employee would have ordinarily earned from rendering services under their employment.

Where the ETP is in relation to a redundancy, it is not considered to form part of their ordinary earnings (salary and wages) and therefore is not subject to SG.

Taxing genuine redundancies

Genuine redundancies are the main ETP that cause frustration and confusion. The confusion is often two fold, with a) determining whether the ETP is in fact a genuine redundancy and b) the calculation of the tax amount on the ETP.

Merely calling the ETP a “redundancy” does not mean that it is treated as a redundancy for tax purposes. A redundancy can be genuine or non-genuine, but only a genuine redundancy receives concessional tax treatment.

The basic requirement for a genuine redundancy payment is that it must be “received by an employee who is dismissed from employment because the employee’s position is genuinely redundant”.

There are four necessary components listed that fall within this requirement:

  • the payment being tested must be received in consequence of an employee’s termination
  • that termination must involve the employee being dismissed from employment
  • that dismissal must be caused by the redundancy of the employee’s position, and
  • the redundancy payment must be made genuinely because of a redundancy.

Dismissal from employment means that all ties must be severed between the employer and the employee. Therefore the employer cannot terminate the employment of the employee and then re-hire or arrange for the re-hiring of the employee at a later date.

Many employers say an employee “was made redundant” but for the purposes of determining whether it was a genuine redundancy, the position or role must become redundant. This means that the employer hiring someone else to perform the exact same role indicates that the role is not redundant.

Note: There are special considerations for employees in dual capacity roles. See this office for circumstances where that may be applicable.

Tax treatment

The genuine redundancy ETPs are tax free up to a limit based on the employee’s completed years of service with the employer.

The tax-free limit is calculated using the following formula:

Tax-free ETP = base amount + (service amount x years of service)

For the 2014-15 income year:Base amount = $9,514 (indexed annually), and service amount = $4,758 per year. For the 2015-16 income year, these amounts are $9,780 and $4,891.

The amount in excess of this is treated as an ETP and is included in the ETP cap for calculation purposes.

Example: Genuine redundancy calculation

Sonya is a 54-year-old chief financial officer (CFO) who has been working for Green Waste for 10 years. In 2014-15, Green Waste is taken over by a larger company, which already has a CFO. Sonya’s position is no longer needed and her employment is terminated. She accepts a redundancy and is paid $190,000, $140,000 of which she would not have received had she not been redundant. Her other taxable income for the 2014-15 year is $200,000.

Sonya’s payment is a genuine redundancy payment because her position is no longer required, even though the position of CFO still exists – the position does not need to be filled by two people.

The genuine redundancy part of Sonya’s payment of $140,000 is subject to the ETP cap, not the whole-of-income cap. The tax-free part of the payment is $57,094, calculated as:

$9,514 +($4,758 x 10 years of service)

{So, $9,514 + $47,580}

=$57,094

In addition, the balance of $82,906 ($140,000 -$57,094) relevant to the redundancy is taxed as a life benefit ETP and is taxed concessionally because it is under the ETP cap.

For the remaining $50,000 of the ETP (non-genuine redundancy), the lesser of the ETP cap or whole-of-income cap will apply.

Because Sonya has earned $200,000 in other taxable income during that financial year, her calculated whole-of-income cap is zero and is the lower cap. As a result, Sonya’s ETP amount of $50,000 will not receive concessional tax rates and withholding will be at the top marginal rate (49%).

Reporting of an ETP

An employer is required to issue a separate PAYG Payment Summary – employment termination payment where they have terminated an employee’s employment and paid an ETP.

This ETP Payment Summary must be supplied to the employee within 14 days of the employer making the payment and reflects the ETP amount and associated withholding.  It also provides a code that the employee will use when lodging their income tax return at the end of that year.

More information? To find out more, give us a call on 1300 023 782 or email team@cdrta.com.au.

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Craig is the principal consultant of C&D Restructure and Taxation Advisory and has been working in the industry since 1999. Having established C&D Commercial Partners in 2015 the precursor to the current business.

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Post Author: Craig Dangar

Craig is the principal consultant of C&D Restructure and Taxation Advisory and has been working in the industry since 1999. Having established C&D Commercial Partners in 2015 the precursor to the current business.

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