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Ruling

Subject: Employment termination payment

Question 1

Is a payment in lieu of notice made by an employer to an employee whose employment is terminated an employment termination payment?

Advice/Answers

Yes

Question 2

Is a payment made by an employer to an employee pursuant to a deed of settlement and discharge (the Deed) executed by the employee an employment termination payment, if the payment was:

(a) to be in full satisfaction and discharge of all claims and complaints that the employee might have against the employer, where no details of such claims and complaints have been specified; and

(b) to include an unspecified consideration in return for the employee undertaking not to commit, during the restricted period and in the restricted areas, any of the restricted activities as are specified in the deed?

Advice/Answers

Yes

This ruling applies for the following period:

Year ending 30 June  2011

The scheme commences on:

A specified date after 1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Your client (the Taxpayer) and your client's employer (the Employer) mutually agreed to terminate your client's employment following a disagreement between them.

The Taxpayer executed a 'Deed of settlement and discharge' (the Deed) prepared by the Employer. The Taxpayer received from the Employer gross payments which included:

(a) a gross sum in lieu of notice (amounting to a specified number of weeks' salary) and

(b) a gross sum as the 'Settlement' under the Deed (amounting to a specified number of weeks' salary).

With regard to (b) above, the Taxpayer acknowledged and agreed with the relevant clauses of the Deed that:

§ The Settlement is paid by the Employer with a denial of liability.

§ I accept the Settlement in full satisfaction and discharge of all claims and complaints whatever and whether known or unknown to me which I or any person claiming through me may have at any time against the Employer or the Employer's servants or agents or consultants in any way relating to or arising out of my employment with the Employer or its termination (Claims).

§ I release the Employer, its servants and agents from all Claims.

§ The intention of this Deed is (subject to payment of the Settlement) to extinguish all of my Claims and all matters in issue between me and the Employer, and it is to be construed for all purposes to give effect to that intention.

The Deed also contained the following clauses that appear to have imposed a restraint of trade on the Taxpayer:

§ I undertake and agreed that:

§ I will not, without the prior consent in writing of the Employer, directly or indirectly participate, assist or be interested in (whether as a sole operator, partner, associate, consultant, employee, independent contractor, agent, director or in any other capacity) the commission of each Restricted Activity during each Restricted Period in each Restricted Area. I acknowledge that the restraints imposed by this clause are fair and reasonable.

§ For the purposes of the clause above, each of the following activities is a restricted activity:

§ soliciting any customer of the Employer to acquire my products and services directly through another employer or other party that I may have a commercial arrangement with, whether or not that customer ceases to be a customer of the Employer;

§ soliciting any customer who is in a commercial arrangement with the Employer to cease that commercial arrangement;

§ using or disclosing confidential information to the detriment or possible detriment of a customer of me or the Employer.

§ For the purposes of the clause above, the number of months specified herein is a restricted period.

§ For the purposes of the clause above, each of the locations specified herein is a restricted area.

The Taxpayer acknowledged having been paid an unspecified amount of consideration in regard to the restraint of trade imposed on the Taxpayer as per the following clause in the Deed:

§ I accept that fair consideration has been paid to me within the settlement as outlined in this Deed.

The Taxpayer received from the Employer a 'PAYG payment summary - individual non-business' for the period up to the date of termination of employment, on which the gross payments received by the Taxpayer were recorded. The Taxpayer did not receive any 'PAYG payment summary - employment termination payment' from the Employer.

Believing that the Employer should have provided the Taxpayer with a 'PAYG payment summary - individual non-business' and a 'PAYG payment summary - employment termination payment, you sought clarification from the Employer on behalf of the Taxpayer. The Employer responded to you as follows:

Our Financial Controller has looked over your client's termination payment and as you will note from the attached, the mutual separation was agreed to be paid In Lieu of Notice as per your client's contract and treated as a resignation and not a bona fide redundancy.

The Deed of Settlement was a Payment for "restraint of trade" and therefore does not come under an ETP. We feel it is quite clear from the mutual separation and restraint of trade that these are not ETP payments.

Please feel free to contact us if you wish to discuss in more details.

In response to our verbal enquiry as to what the claims and complaints the Taxpayer had against the Employer were, you advised us on the telephone that, to your understanding:

1. basically both the Taxpayer and the Employer agreed to part company because of a fallout over a matter concerning leave entitlement;

2. the Taxpayer had worked for the Employer for a number of years and was entitled to long service leave; and

3. to settle the matter the Employer agreed to pay the Taxpayer an amount provided that the Taxpayer also agreed to the restraint of trade stated in the Deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 82-130

Income Tax Assessment Act 1997 Subsection 82-130(2)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Paragraph 82-135(j)

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 118-22

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Summary

The payment in lieu of notice received by the Taxpayer was an employment termination payment. The entire Settlement amount accepted by the Taxpayer under the Deed was an employment termination payment because it cannot be dissected.

Detailed reasoning

Employment termination payment

From 1 July 2007 the taxation treatment of payments made in consequence of the termination of any employment of a taxpayer changed. These payments, formerly known as eligible termination payments, are now called employment termination payments. Where the payment is made during the life of a taxpayer the employment termination payment is known as a life benefit termination payment (subsection 82-130(2) of the Income Tax Assessment Act 1997 (ITAA 1997)).

Section 995-1 of the ITAA 1997 states:

employment termination payment has the meaning given by section 82-130.

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another persons death, in consequence of the termination of the other persons employment; and

(b) it is received no later than 12 months after the termination (but see subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

Payment in consequence of the termination of employment

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the phrase 'in consequence of termination of employment' has been interpreted by the courts in several cases.

Of note are the decisions made by the High Court in Reseck v. Federal Commissioner of Taxation (1975) 49 ALJR 370; (1975) 6 ALR 642; (1975) 5 ATR 538; (1975) 75 ATC 4213; (1975) 133 CLR 45 (Reseck) and the Full Federal Court in McIntosh v Federal Commissioner of Taxation (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325 (McIntosh).

Both Courts' views were that for a payment to be made in consequence of the termination of employment it had to follow on as a result or effect of the termination of employment. Additionally, while it is not necessary to show that termination of employment is the sole or dominant cause, a temporal sequence alone would not be sufficient.

The Commissioner has issued Taxation Ruling TR 2003/13 (TR 2003/13) which discusses the meaning of the phrase, taking into account the views of the courts.

In paragraph 5 of TR 2003/13 the Commissioner states:

a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment follows as an effect or result of the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

As further stated by the Commissioner in paragraph 6 of TR 2003/13, there must be:

a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

Therefore, if the payment follows as an effect or results from the termination of employment, the payment will be made in consequence of the termination of employment for the purposes of subparagraph 82-130(1)(a)(i) of the ITAA 1997.

It should also be noted that a payment received in consequence of the termination of employment does not arise from the performance of services under a contract of employment. Rather, the payment arises from the termination of those services.

Payments received by the Taxpayer

Following the termination of the Taxpayer's employment by mutual agreement, the Taxpayer received from the Employer, among other entitlements, a payment in lieu of notice and a payment pursuant to the Deed the Taxpayer executed. It is convenient to consider the payment in lieu of notice first.

Payment is made in consequence of the termination of employment

As is required by sub-paragraph 82-130(1)(a)(i) of the ITAA 1997, for a payment to be an employment termination payment there must be a payment that is made in consequence of the termination of employment of the taxpayer.

The termination of employment and the payment in lieu of notice are all intertwined and connected. If not for the termination of employment, the Employer would not have made the payment in lieu of notice, and the other entitlements, to the Taxpayer. The Commissioner, therefore, accepts that the Taxpayer received the payment in lieu of notice in consequence of the termination of the Taxpayer's employment.

The payment is received no later than 12 months after termination

The second condition for a payment to be an employment termination payment, as is stipulated in paragraph 82-130(1)(b) of the ITAA 1997, is that the payment must be received within 12 months of the employee's termination of employment, unless they are covered by a determination exempting them from the 12 month rule.

Following the termination of the Taxpayer's employment, the Taxpayer received the various payments in consequence thereof (including the payment in lieu of notice) on the same day. The requirement of paragraph 82-130(1)(b) of the ITAA 1997 has therefore been met.

Not a payment mentioned in section 82-135 of the ITAA 1997

Section 82-135 of the ITAA 1997 lists payments that are not employment termination payments. These include (among others):

§ superannuation benefits; and

§ unused annual leave or long service leave payments.

As a payment in lieu of notice made to an employee consequent upon the termination of employment does not fall within the exceptions listed in section 82-135 of the ITAA 1997, the requirement of paragraph 82-130(c) of the ITAA 1997 has therefore been met.

As all the requirements under subsection 82-130(1) of the ITAA have been met, the payment in lieu of notice made to the Taxpayer by the Employer on termination of the Taxpayer's employment was an employment termination payment.

Payment received by the Taxpayer under the Deed

Although the Employer maintained that the payment made under the Deed was a payment for restraint of trade and therefore does not come under an employment termination payment, the wording of the Deed, prepared by the Employer, indicates overall that the Settlement accepted by the Taxpayer from the Employer was intended to do two things:

(a) satisfy in full, discharge and extinguish all claims and complaints that the Taxpayer might have against the Employer or their servants or agents in relation to, or arising out of, the Taxpayer's employment or the termination of the employment, following the fallout between the two over the leave issue and the leave-entitlement issue; and

(b) include a consideration paid to the Taxpayer in return for the Taxpayer undertaking to be bound by the restraint of trade imposed on the Taxpayer under the Deed.

However, the Deed does not specify how much out of the payment made pursuant to the Settlement was for the satisfaction, discharge and extinguishment of claims and how much was the consideration for the restraint of trade.

In Administrative Appeals Tribunal (AAT) Case 7/2005; 2005 ATC 162; [2005] AATA 583; 59 ATR 1161, the taxpayer entered into a deed of settlement in respect of claims the taxpayer made against the employer. Under the deed, part of the payment received by the taxpayer was represented as a termination payment. The taxpayer submitted that the characterisation of the payment as a termination payment was not determinative and that the payment was in fact compensation for wrong or injury suffered in the workplace hence free from tax. While agreeing that the characterisation of the payment in the deed was not determinative, the Commissioner disagreed that the payment was a CGT- exempt capital sum. Senior Member Ettinger, who heard the case, held at 2005 ATC 171 that:

47. I am mindful that whilst the judgments in Reseck, McIntosh and Le Grand (Le Grand v. Commissioner of Taxation [2002] FCA 1258; (2002) 2002 ATC 4907; (2002)

195 ALR 194; (2002) 51 ATR 139; (2002) 124 FCR 53) , which are binding on this Tribunal, vary somewhat, they are not at odds in holding that termination need not be the dominant cause of the payment for there to be the conclusion drawn that a payment is made "in consequence upon" the termination of employment.

At 2005 ATC 173, Senior Member Ettinger further noted that:

70. Mindful of the evidence and applying the case law as noted above, I was satisfied that the payment of $3,176,322 was "payment made in respect of the taxpayer in consequence of the termination of any employment of the taxpayer…", that there was not just a temporal connection but that the causal nexus had been established between the payment of $3,176,322 and the termination of employment of the Applicant. Accordingly, the payment must be taxed as an ETP pursuant to section 27A of the Act.

If the Settlement accepted by the Taxpayer were clearly stated in the Deed as comprised:

(a) a specified amount for discharging and extinguishing all claims against the Employer; and

(b) another specified amount as the consideration for the restraint of trade undertaken by the Taxpayer,

the Commissioner would treat:

1. the amount in (a) above as an employment termination payment, since it was a payment made in respect of the Taxpayer in consequence of the termination of the Taxpayer's employment, based on the AAT case just cited, and since it also met the other conditions stipulated in paragraphs 82-130(b) and (c); and

2. the amount in (b) above as a payment for or in respect of a legally enforceable contract in restraint of trade by the Taxpayer, which is not an employment termination payment by reason of paragraph 82-135(j) of the ITAA 1997.

If that had been the case, section 104-35 of the ITAA 1997 would have applied to the amount in (b) above. Relevantly, section 104-35 states that:

(1) CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity.

Example:

You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this.

You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right.

(2) The time of the event is when you enter into the contract or create the other right.

(3) You make a capital gain if the *capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.

Example:

To continue the example: If you paid your lawyer $1,500 to draw up the contract, you make a capital gain of:

$20,000 - $1,500 = $18,500

Pursuant to subsection 104-35(1) of the ITAA 1997, CGT event D1 happened when the Taxpayer executed the Deed, as a contractual right was created under the Deed for the Employer to enforce, if necessary, the restraint of trade and other obligations undertaken by the Taxpayer. Pursuant to subsection 104-35(3), the Taxpayer made a capital gain when the Taxpayer accepted the consideration for the restraint of trade, net of any incidental costs the Taxpayer might have incurred in relation to the event. The capital gain so made would be assessable under

section 102-5 of the ITAA 1997.

However, as noted before, the Deed does not specify the amount of the consideration paid to the Taxpayer in respect of the restraint of trade agreed to by the Taxpayer. A specific clause of the Deed merely states that

I accept that fair consideration has been paid to me within the settlement as outlined in this Deed (emphasis added).

As the Settlement amount cannot be dissected, the Commissioner considers it fair and reasonable to treat the entire Settlement amount accepted by the Taxpayer under the Deed as an employment termination payment for income tax purposes. Any capital gain that the Taxpayer would have made under section 104-35 of the ITAA 1997 (had the amount of consideration for restraint of trade been specified in the Deed) is treated as being reduced to zero pursuant to section 118-20 of the

ITAA 1997, which states that:

(1) A capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in

(a) your assessable income or exempt income; or

(b) …

(2) The gain is reduced to zero if it does not exceed:

(a) the amount included; or

(b) …

An employment termination payment is taken to be included in the assessable income of the employee who receives the employment termination payment, as section 118-22 of the ITAA 1997 states that:

In applying section 118-20, treat a superannuation lump sum or an employment termination payment that you receive as being included in your assessable income.

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