Losing your job can be one of the most stressful events to occur during a lifetime but sometimes the blow is softened by a payment from your former employer.
Sadly, the tax consequences of receiving such a payment can be anything but straightforward, which means that you need to understand exactly why you have received the payment and what your potential tax obligations are.
Because payments when leaving your job are often large and the tax treatment unclear, if you have received such a payment, you should seek professional tax advice on how it should be treated.
Most payments upon leaving employment take one of three forms; a redundancy payment, an early retirement payment or an employment termination payment (ETP).
Sometimes, just to complicate matters, payments can be a mixture of two types. Whilst redundancy and early retirement payments are taxed similarly, ETP’s are taxed very differently so it’s essential to understand what form the payment you are receiving takes.
A genuine redundancy payment is a payment made as a result of your dismissal from your job because the job you were doing has been abolished.
Such payments are tax-free up to certain limits and might include:
- payment in lieu of notice
- severance payment of a number of weeks’ pay for each year of service
- a gratuity or ‘golden handshake’
Although there is a tendency for many employees who lose their job to try to claim that the payment was related to redundancy, a true redundancy payment must meet a substantial list of criteria to qualify. If it doesn’t qualify, it’s taxed as an employment termination payment.
The following payments are never part of a genuine redundancy payment and nor are they treated as ETP’s. You would be taxed at normal rates on any of these:
- salary, wages or allowances owing to you for work done or leave already taken for work completed
- lump sum payments of unused annual leave or leave loading paid on termination of employment
- lump sum payments of unused long service leave paid on termination of employment under a formal arrangement
- payments made in lieu of superannuation benefits.
Genuine redundancy payments are taxed at special rates.
Part of the redundancy payment can be paid tax-free. The tax-free limit consists of two elements, a base amount and an annual amount for each year of service. Both are indexed annually. For 2018-19, the base amount is $10,399 and the annual service amount is $5,200.
Any amount over the tax-free limit is treated as an employment termination payment
An approved early retirement scheme is a scheme that an employer puts into place to encourage certain groups or classes of employees to retire early or resign. For a scheme to be eligible for tax concessions, it must be open to all the employer’s employees or all employees of a certain class (for example, those in a defined age range or with a certain skill set) and must be approved by the Commissioner of Taxation before payments are made.
Early retirement scheme payments are tax free, up to a limit based on the number of years the employee has worked for their employer. To qualify:
- retirement must be “early” i.e. earlier than 65, or before any other compulsory retirement age, if sooner.
- payments must be at “arms-length” values
- there must be no arrangement for re-employment
The tax-free limit is the same as for a genuine redundancy payment. Any amount over the tax-free limit is treated as an employment termination payment.
Employment Termination Payments (ETP’s)
The third category of payment – and probably the most common in practice – are ETP’s. These are lump sum payments made to an employee when they cease working for their employer. Common examples of ETPs include golden handshakes, contractual termination payments, payments for unused sick leave, payments for unused roster days off, payments in compensation for loss of employment or wrongful dismissal, and payments in lieu of notice of termination.
As we’ve already established, genuine redundancy payments and early retirement schemes are not ETP’s up to the tax-free limit, but the excess over that limit will be taxed as an ETP.
ETPs are taxed differently according to whether they relate to the termination of the taxpayer’s employment (“life benefits”) — as would normally be the case — or to a termination of employment arising as a result of the death of the employee (“death benefits”).
In some cases, part or all of an ETP may be tax-free. The two instances where this might be the case are where part of the payment relates to:
- Employment prior to 1 July 1983. At this distance of time, such a payment would be rare so in practice most tax-free payments will relate to invalidity.
The part of a life benefit ETP that is not the tax-free component is the taxable component. This is the portion of the ETP that is actually taxed.
ETPs are taxed at concessional rates (either 17% or 32%) up to a certain limit, or ‘cap’. The top rate of tax applies to amounts in excess of the cap.
The actual tax calculation for an ETP can be very complex, largely because there are two caps, each with different rules, and the way your ETP is taxed depends on which cap applies to you.
If you’ve received an ETP during the year, you’d be very strongly advised to use a tax professional to help you work out your tax liability.
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