Termination Payments: A New Landscape for Employers

Prior to July 1, 2007, payments made as a consequence of a termination of employment were regarded as eligible termination payments. More importantly for employers and relevant employees, such payments were generally able to be rolled over into a superannuation fund tax free to the employee.

Under the simplified superannuation reforms introduced by the government as part of the 2006 Federal Budget, 'employment termination payments' replace eligible termination payments. This new concept of a termination payment encompasses any termination payment made by an entity other than a superannuation entity.

As a consequential amendment, reasonable benefit limits have been abolished from 1 July 2007. Instead, under the new regime, employment termination payments received in a given year (or where the payment relates to a 'single termination' and the payment is split over more than one year) will receive concessional tax treatment for amounts paid below a cap called the lower employment termination payments cap. The cap is presently set at $140,000, and will be indexed.

It is a condition of access to the concession that, generally, employment termination payments be made within 12 months of the relevant termination. Transitional arrangements may apply to payments made between 1 July 2007 and 30 June 2012 (known as 'transitional termination payments'). An employee can direct that their transitional termination payment be made to a complying superannuation fund or to the purchase of an annuity, in which case the payment is tax-free to the employee.

All of this raises several questions for an employer attempting to unravel the new landscape following the Simpler Super reforms.

* What is an 'employment termination payment'?

* What is excluded from the new regime?

* What transitional arrangements exist?

* What are the tax consequences of an employment termination payment?

This article addresses these questions at a high level, with a view to providing employers with a guide to understanding the new landscape for termination payments and their tax treatment. It does not, however, go into how the new rules apply to death benefit termination payments.

What is an employment termination payment?

Under the Income Tax Assessment Act 1997 (the Act), an employment termination payment is a lump sum payment that is made to a person in consequence of the termination of the person's employment. The Act deems the termination of employment as including retirement from employment and cessation from employment because of death. Beyond this, there is a large body of case law which has considered the meaning of the phrase 'in consequence of'  the termination of employment which are not explored in this article.

There are two kinds of payments contemplated by the Act:

(a) a life benefit termination payment which is a payment made as a consequence of a person's termination of employment, other than as a result of death and

(b) a death benefit termination payment which is a payment made to a person after another person's death.

As noted above, the Act generally requires that a payment be made within 12 months of the termination in order to qualify for concessional tax treatment as an employment termination payment. However, there are provisions that permit the Commissioner of Taxation to allow a payment made after the expiry of the 12-month period to be taxed at concessional rates. In order to do so, the Commissioner may make a determination in relation to that particular payment, or to a class of payments.

The factors that the Commissioner must have regard to in making such a determination are:

* the circumstances of the employment termination, including any dispute in relation to the termination

* the circumstances of the payment

* the circumstances of the person making the payment and

* any other relevant circumstances that the Commissioner has been forwarded.

The Explanatory Memorandum to the Tax Laws Amendment (Simplified Superannuation) Bill 2006 (the EM), sets out the following examples to illustrate the circumstances in which it is intended the Commissioner would, or would not, issues such a determination.

Example 1

Stephen is dismissed from his employment. No employment termination payment is made. Stephen commences legal action against the employer to secure payment of amounts he believes he was entitled to on termination and to seek damages for unfair dismissal.

After a lengthy court process, lasting more than 12 months, Stephen is successful in his claim and a payment is made by his employer. Stephen writes to the Commissioner to seek relief from the 12-month rule. The Commissioner, having regard to the circumstances of the payment, determines that the delay in payment is reasonable given that it arose as a result of a legal dispute over entitlement.

(Page 131 of the EM)

Example 2

Rithy is employed part-time by Erica. They have an agreement which provides for a payment to Rithy on the termination of his employment. Rithy is also employed part-time with Louise. They also have an agreement which provides for a payment on the termination of employment. On 1 July Rithy terminates his employment with both employers in order to take a holiday. At Rithy's request neither employer makes an immediate payment. On 1 July the following year Louise pays Rithy $140,000. Rithy then enters into an arrangement with Erica to defer the payment of the amount she owes him for another year in order to secure a better taxation outcome.

As the deferral of the payment would mean that it occurs more than 12 months after the termination of employment Rithy seeks the Commissioner's agreement to determine that the 12-month rule does not apply. Given the circumstances of the request and of the payment the Commissioner declines to provide such a determination.

(Pages 131-132 of the EM)

Payments received outside 12 months will be taxed as ordinary income of the employee at the relevant marginal tax rates.

What is excluded from being an employment termination payment?

Consistent with the regime prior to 1 July 2007, the Act stipulates that a number of payments are prevented from qualifying as employment termination payments. The following payments are expressly stated to not be employment termination payments:

* superannuation benefits

* payments from a pension or an annuity

* unused annual leave payments

* unused long service leave payments

* part of a genuine redundancy payment or early retirement scheme payment that is tax-free

* foreign termination payments

* advances on loans on an arm's length basis

* a payment that is deemed to be a dividend

* reasonable capital payments for personal injury and reasonable capital payments for restraint of trade and

* payments that result from the commutation of a superannuation income stream that are wholly applied in paying a contribution surcharge.

What is a transitional termination payment?

Certain transitional provisions were adopted to reduce the risk that employees with an entitlement (that existed prior to 10 May 2006) to a termination payment might have terminated employment prior to that date in order to access the pre-1 July 2007 provisions, including the ability to have an unlimited amount of such a payment made to a superannuation fund.

A life benefit termination payment will be a 'transitional termination payment'  where the following criteria are met:

* the payment is made before 1 July 2012

* the employee is entitled to the payment under the terms of a contract or under a law of the Commonwealth, or a State, or a Territory, an instrument under such a law, or a workplace agreement

* the contract or law must have been in force prior to 10 May 2006

* the contract or law must specify the amount of the payment, or the method used to determine the specific amount of the payment.

A key element of the test for the transitional rules is the existence of an entitlement prior to 10 May 2006 to a termination payment. This will include arrangements where the contract refers to the amount of the payment by way of specific amount, a method or formula for working out the amount, or to payments made in kind (for example, a transfer of shares to the employee).

The tax treatment of life benefit termination payments

In general terms, an individual who receives the payment after they reach their preservation age, or in the year in which they will reach their preservation age, pays less tax on the payment than if it were received by an individual who at the time of payment is below their preservation age.

A person's preservation age depends on the person's date of birth as set out in Table 1.

There are two components of a life benefit termination payment. The first is the tax-free component. The second is the taxable component.

The tax-free component

The tax-free component is that portion of an employment termination payment that relates either to invalidity or to pre-July 1983 employment. That portion is not subject to tax.

Generally, an employment termination payment contains an invalidity segment where the payment is made to a person because they are no longer able to work as a result of physical or mental ill health. There are prescribed requirements for certification.

The taxable component

The taxable component of the payment is included in an individual's assessable income. Where an individual has reached their preservation age at the date of the payment they will pay no more than 15 per cent tax on the taxable component, up to a cap of $140,000.

A 30 per cent rate of tax applies where a person has not attained their preservation age.

Amounts received above the cap are taxed at the top marginal rate.

The tax treatment of transitional termination payments

Transitional termination payments are taxed at different rates, depending upon whether or not a person has attained their preservation age, and whether or not the employee received the payment or directs it to be paid to a complying superannuation fund (in which case, it becomes a 'directed termination payment').

Payment received by employee below preservation age

The tax-free component of a transitional termination payment made to a person below preservation age is not subject to tax. Any remaining part of the payment (the taxable component) is included in a person's assessable income and taxed as follows.

The amount of the taxable component that is below the upper employment termination payments cap of $1 million is taxed at no more than 30 per cent. Any amount above that is taxed at a rate equal to the top marginal rate. The upper cap amount of $1 million is expressed to be the upper limit on the amount of concessions that may be received during the transitional period. This means that the taxable components of all previous transitional termination payments will effectively reduce a person's upper cap for all future payments during the transitional period between 1 July 2007 and 30 June 2012.

Payment received by employee at or above preservation age

The tax-free component of a transitional termination payment made to a person who is at or above their preservation age is not subject to tax. Any remaining part of the payment (the taxable component) is included in a person's assessable income and taxed as follows.

The amount of the taxable component that does not exceed the lower capped amount of $140,000 is taxed at a rate of 15 per cent. The amount that exceeds the lower capped amount but does not exceed the upper capped amount of $1 million will be taxed at no more than 30 per cent. Any amount received above the upper capped amount will be taxed at the top marginal rate.

Directed termination payments

Transitional termination payments may be rolled over into superannuation. These are then regarded as 'directed termination payments' Directed termination payments are not assessable income of the recipient, but are taxed in the hands of the superannuation fund.

The taxable component of a directed termination payment is included in the fund's assessable income, but will not count towards the person's 'concessional contributions' cap limit. As part of the Simpler Super reforms, the Act limits the level of concessional contributions to superannuation receiving concessional tax treatment to $50,000 per person per financial year, indexed annually.

An employer who proposes to pay a transitional termination payment must provide a pre-payment statement to their employee. That statement is required to outline the components (ie the tax-free and taxable components) of the proposed payment. The form must also ask the individual to make a choice between receiving the payment themselves, or making a directed termination payment (that is, a payment to a complying superannuation fund of their choice, or a payment towards the purchase of an annuity).

Conclusion

Having regard to the above, it is clear that the regulatory landscape for employers following the Simpler Super reforms will be different in the context of termination payments. Where an employer proposes to make an employment termination payment, it needs to carefully consider whether the payment is in fact an employment termination payment, or if it is excluded from the new rules for the concessional taxation of termination payments.

Finally, the possible application of the transitional rules until 30 June 2012 warrants close scrutiny by an employer. This is important as it may provide the employee in question with the option of directing the payment to their superannuation fund or the purchase of an annuity and thus avoiding the tax treatment that would otherwise apply to the payment.

* New arrangements apply to employment termination payments made by employers (formerly known as eligible termination payments)

* Some types of employer payments are excluded from the definition of an employment termination payment

* If an employee was entitled to a termination payment prior to 10 May 2006, special transitional rules may apply

By Michael Chaaya, Senior Associate, Mallesons Stephen Jaques

Michael Chaaya can be contacted on (02) 9296 2420 or via email at michael.chaaya@mallesons.com.

Table 1: Preservation age as determined
by date of birth

Date of birth               Preservation age

Before 1 July 1960                55
1 July 1960--30 June 1961         56
1 July 1961--30 June 1962         57
1 July 1962--30 June 1963         58
1 July 1963--30 June 1964         59
After 30 June 1964                60