Redundancy payments and tax

Analysis

Redundancy payments and tax

This article summarises the income tax issues associated with redundancy payments.

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This article summarises the income tax issues associated with redundancy payments.
 
Shirley Murphy, Tax and Superannuation consultant, prepared this article.
 
Definition and scope
 
Concessional tax treatment is given to 'genuine redundancy payments'. If a payment qualifies, part of the payment is tax free, with the tax-free amount being based on the number of years of service with the employer.
 
The circumstances in which the Tax Office will treat a payment as a genuine redundancy payment are explained in Taxation Ruling TR 2009/2, issued on 22 April 2009.
 
Genuine redundancy payments
 
A genuine redundancy payment is one 'received by an employee who is dismissed from employment because the employee’s position is genuinely redundant' (s83-175 of the Income Tax Assessment Act 1997).
 
To be a genuine redundancy payment, a payment must satisfy four conditions.

1. Payment in consequence of the termination. The payment must be received in consequence of the termination of the employment and not for any other reason.This basically means that the payment 'follows on' from the termination in the sense of being caused by it (rather than being caused, for example, by an employer’s desire to made a personal gift to the employee for another reason).

2. Dismissed from employment. The termination must involve the employee being dismissed from employment because the employer considers that there is no available job for which the employee is suited. Dismissal requires a decision to terminate employment at the employer’s initiative without the consent of the employee. A dismissal may, however, occur where an employee has indicated they are interested in having their employment terminated (eg after the employer asks for expressions of interest in having a redundancy package), provided the employer makes the final decision.
 
Dismissal may include constructive dismissal, eg where an employee resigns after the employer offers work in an alternative position that is inappropriate given the employee’s skills or experience.
 
To be a dismissal, all employment with the employer must end. The exception to this is where a person holds two positions with the employer, eg one as director and one as employee. In that case, the person may continue to have a relationship with the employer even though their actual employment ends (and they continue to hold office as director).
 
3. Dismissal is caused by redundancy. The dismissal must be caused by the redundancy of the employee’s position. A position is redundant if the employer determines that it is superfluous to the employer’s needs and the employer does not want it occupied by anyone. If an employer reallocates the duties and functions attached to a particular position to another position, the former position is redundant.
 
A dismissal is not caused by redundancy if the employee is dismissed because of personal acts or default, eg because of unsatisfactory performance.
 
While dismissal of an employee when a business is being reorganised may suggest a redundancy, this will not always be the case and the dismissal may, for instance, be caused by the employee’s under performance. Careful consideration would need to be given to what was the most influential cause of the dismissal.
 
4. Genuine redundancy. The payment must be made genuinely because of a redundancy. A redundancy would not be genuine if it is only a redundancy because it is called that by the employer and employee or if it is only treated as such for tax purposes.
 
Other conditions that must be satisfied
 
The legislation and the tax ruling make it clear that various other conditions must be satisfied for a payment to receive concessional tax treatment. These are:
  • the employee must be less than 65 at the date of dismissal (or a lower age if their retirement is to be at a lower age)
  • the termination is not at the end of a fixed period of employment, unless the employee works under rolling fixed-term contracts that establish an ongoing employment relationship
  • if the employer and employee are not dealing with each other at arm’s length (eg they are related to each other), the payment is not greater than the amount that could reasonably be expected to have been paid if they had been dealing with each other at arm’s length
  • there is no arrangement between the employer and employee (or between the employer and another entity, eg a subsidiary of the employer or another employer) for the dismissed employee to be re-employed after the termination — this condition would not prevent the former employee being engaged as an independent contractor
  • the payment is not in lieu of superannuation benefits.
 
Tax issues
 
If a termination payment satisfies all of these conditions, the tax treatment of the payment is determined in three steps.

1. Any amounts that are taxed under specific tax rules (eg lump sums for unused annual leave or long service leave) are separated out and taxed under their own rules.

2. Work out the tax free amount of the redundancy payment. The tax free amount is worked out under the formula:

Base amount ($7350 for 2008–09) + Service amount ($3676 for 2008–09) for each completed year of service.
The relevant amounts for 2007–08 were $7020 and $3511 respectively.
 
(3) The amount in excess of the tax free amount is generally taxed as an employment termination payment at the rate that is appropriate to the employee’s age.
 
Example: Percy's position becomes redundant when the sales division of his employer is outsourced. Percy is aged 51 and has worked for his employer for 23 years and 5 months. The $120,000 redundancy payment that he is paid on 1 May 2009 satisfies the conditions set out in s83-175 and in Taxation Ruling TR 2009/2.
 
The redundancy payment is taxed as follows.
 
1. No part of the $120,000 is taxed under other rules. Although Percy may receive a payment for unused leave or in lieu of notice, for example, as long as this is a separate payment it is taxed under its own rules and does not need to be separated from the redundancy payment.
 
2. The tax free amount of the redundancy payment is:
$7350 + $84,548 ($3676 x 23 years) = $91,898
3. The $28,102 in excess of the tax free amount ($120,000 – $91,898) is taxed as an employment termination payment. Because Percy is aged 51 at the time of payment, the $28,102 is included in his assessable income and taxed at his ordinary tax rates but with a maximum rate of 31.5%.
 
Source: Shirley Murphy, Tax and Superannuation consultant and writer.
 
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