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Ruling

Subject: Retiring gratuity on termination of employment

Issue 1

Questions

1. Is the payment of $Y received by your client an employment termination payment in accordance with subsection 82-130(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

2. Is payment of $X received by your client considered to be a genuine redundancy payment in accordance with section 83-175 of the ITAA 1997?

Advice/Answers

1. No.

2. Yes.

Issue 2

Questions

3. Is the payment of a retiring gratuity on termination of employment to your client allowable as a deduction under section 25-50 of the ITAA 1997 to the Employer?

4. Will the Commissioner of Taxation exercise the discretion under section 109 of the Income Tax Assessment Act 1936 (ITAA 1936) to allow a deduction to the Employer for the retiring gratuity of $X paid to your client as reasonable?

5. Will the Commissioner exercise the discretion under section 109 of the ITAA 1936 to allow a deduction to the Employer for the retiring gratuity of payment $Y paid to your client as reasonable?

Advice/Answers

3. Yes.

4. Yes.

5. No

This ruling applies for the following period

Year ending 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

Your client has been employed by the Employer and related entities since the mid 1980s.

Your client is the spouse of a director of the Employer. Your client is also related to a shareholder and associate of the Employer.

The Employer also employs a number of unrelated employees.

The directors of the Employer had discussions about the efficient operation of the company. A reorganisation of office functions and activities ensued and it was decided that the role carried out by your client be divided up and allocated among other staff members.

Your client's position was subsequently made redundant in the relevant income year. There was no other termination of employment at the time.

At the time of dismissal there was no arrangement between your client and the Employer or between the Employer and another person, to employ them after the dismissal.

There was difficulty quantifying the value of the redundancy component. So it was suggested that a figure be applied on a similar basis to that used in section 83-170 of the ITAA 1997 in respect of genuine redundancy payments based on a period that was less than the period of employment with the Employer. Based on this, a payment of $Y will be made to your client.

The total proposed payment to be made to your client comprises of:

· Termination payment - gratuity $X

· Termination payment - redundancy component $Y

You explain that during the early years it appears that your client was underpaid in comparison to the work performed by them due to the fact that your client was a family member. The Employer is primarily a family practice and consequently involvement by family members was not always rewarded on an adequate commercial basis. The underpayment related primarily to the time spent entertaining clients and potential clients, visiting professionals aimed at increasing the Employee's clientele and standing in the relevant profession and also payments below the award rates in earlier years.

Your client's underpayment has been estimated and a payment of $X will be made to your client.

The proposed payment will be made no later than 12 months after termination of your client's employment.

Provision for superannuation has also been made for your client which was paid as a lump sum amount in the relevant income year.

Your client is under 65 years of age.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 27F.

Income Tax Assessment Act 1936 Section 109

Income Tax Assessment Act 1997 Section 25-50

Income Tax Assessment Act 1997 Section 82-130.

Income Tax Assessment Act 1997 Subsection 82-130(1).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(a).

Income Tax Assessment Act 1997 Subparagraph 82-130(1)(a)(i).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(b).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(c).

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

Income Tax Assessment Act 1997 Section 82-135.

Income Tax Assessment Act 1997 Subsection 82-135(e).

Income Tax Assessment Act 1997 Section 83-175.

Income Tax Assessment Act 1997 Subsection 83-175(1).

Income Tax Assessment Act 1997 Subsection 83-175(2).

Income Tax Assessment Act 1997 Subsection 83-175(3).

Income Tax Assessment Act 1997 Subsection 83-175(4).

Income Tax Assessment Act 1997 Section 995-1.

Reasons for decision

Issue 1

Summary of decision

In this case the payment of $Y is a genuine redundancy payment. As the payment is below the tax-free amount of a genuine redundancy payment, the entire amount of the payment is the tax-free part of a genuine redundancy payment. This tax-free amount is not assessable income and is not exempt income.

The payment of $X was not received by your client in consequence of the termination of their employment and, therefore, is not an employment termination payment. The payment is primarily made for underpayments for your client's employment with the Employer and is to be included in the subsequent income year as ordinary assessable income.

Detailed reasoning

Employment termination payment

Section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that:

employment termination payment has the meaning given by section 82-130 of the ITAA 1997.

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

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 person's death, in consequence of the termination of the other person's employment; and

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

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

An employment termination payment, where the payment is made during the life of a taxpayer, is known as a life benefit termination payment (subsection 82-130(2) of the ITAA 1997).

To determine if any part the payment your client received from the Employer is an employment termination payment all the conditions in section 82-130 of the ITAA 1997 will need to be satisfied.

Failure to satisfy any of the conditions will result in a payment not being considered an employment termination payment.

Paid as a consequence of the termination of employment

It should be noted that the phrase 'in consequence of the termination of your employment' is not defined in the legislation. However, both the Courts and the Commissioner have considered the meaning of this phrase.

In light of these decisions, the Commissioner discusses the meaning of the phrase in Taxation Ruling TR 2003/13 titled Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of'.

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.

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 Taxation¹ (Reseck) and the Full Federal Court in McIntosh v Federal Commissioner of Taxation² (McIntosh).

In Reseck, Justice Gibbs stated:

Within the ordinary meaning of the words, a sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination... It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment...

While Justice Jacobs stated:

It was submitted that the words 'in consequence of' import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a 'following on'.

In looking at the phrase 'in consequence of' the Full Federal Court in McIntosh considered the decision in Reseck. Justice Brennan considered the judgments of Justice Gibbs and Justice Jacobs in Reseck and concluded that their Honours were both saying that a causal nexus between the termination and payment was required, though it was not necessary for the termination to be the dominant cause of the payment.

Suffice it to say that 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.

Furthermore, in Le Grand v Federal Commissioner of Taxation³ (Le Grand), the issue before the Federal Court was whether an amount received by the applicant as a result of accepting an offer of compromise in respect of claims brought by him against his former employer, in relation to the termination of his employment was in whole, or in part, an ETP. It was held that a settlement payment for litigation in relation to a taxpayer's dismissal was an ETP.

Justice Goldberg stated:

I am satisfied that there is a sufficient connection between the termination of the applicant's employment and the payment to warrant the finding that the payment was made 'in consequence of the termination' of the applicant's employment. I am satisfied that the payment was an effect or result of that termination in the sense that there was a sequence of events following the termination of the employment which had a relationship and connection which ultimately led to the payment. True it is that the payment was made not only to settle the applicant's claim for common law damages for breach of the employment agreement but also for statutory damages...

Justice Goldberg concluded that the test for determining when a payment is made in consequence of the termination of employment is that which was articulated by Justice Gibbs in Reseck. Thus, for the payment to have been made in consequence of the termination of employment, the payment must follow as an effect or result of the termination of employment. As earlier stated in paragraph 6 of TR 2003/13, there must be 'a causal connection between the termination and the payment even though the termination need not be the sole or dominant cause of the payment'.

The Full Federal Court in Dibb v Federal Commissioner of Taxation⁴, has applied the above decisions in finding that the payment received by the taxpayer under a Deed of Release to settle various causes of action against the employer following the termination of employment was an ETP.

Paragraph 31 of TR 2003/13 the Commissioner states:

It is clear from the decision in Le Grand, that when a payment is made to settle a claim brought by a taxpayer for wrongful dismissal or claims of a similar nature that arise as a result of an employer terminating the employment of the taxpayer, the payment will have a sufficient causal connection with the termination of the taxpayer's employment. The payment will be taken to have been made in consequence of the termination of employment because it would not have been made but for the termination.

The essence of this analysis is that if the payment follows as an effect or a result of 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. The termination of the payment need not be the sole or dominate cause of the payment.

The question of whether a payment is made in consequence of the termination of employment is determined by the relevant facts and circumstances of each case.

The directors of the Employer had discussions about the efficient operation of the company. A reorganisation of office functions and activities ensued and it was decided that the part-time role carried out by your client be divided up and allocated among other staff members.

Your client's position was subsequently made redundant in the relevant income year.

Payment described as 'Termination payment - Redundancy component'

From the facts it is clear that this payment will be made in consequence of the termination of your client's employment. The termination of employment and the payment of $Y are intertwined and connected. If not for the termination of your client's employment payment A would not have been made.

Therefore, the payment is considered to be received by your client in consequence of the termination of their employment and the requirement under subparagraph 82-130(1)(a) of the ITAA 1997 has been met for this payment.

Payment described as 'Termination payment - gratuity'

In relation to payment of $X you explain that, during the early years of your client's employment, it would appear that your client was underpaid in comparison to the work performed by them due to the fact that your client was a family member. The Employer is primarily a family business and consequently involvement by family members was not always rewarded on an adequate commercial basis. The underpayment related primarily to the time spent entertaining clients and potential clients, visiting professionals, aimed at increasing the Employee's clientele and standing in the relevant profession and also payments below the award rates in earlier years. Your client's underpayment has been estimated at a certain amount per year for a period of a number of years totalling $X.

It is clear that payment of $X is made to rectify your client's underpayment over the years with the Employer. The payment, as advised by you, relates primarily to underpayment for your client's time with the Employer. Thus the payment does not follow as an effect or result of the termination of your client's employment.

The payment of $X is not considered to be received by your client in consequence of the termination of their employment and the requirement under subparagraph 82-130(1)(a) of the ITAA 1997 has not been met for this payment. As all conditions under subsection 82-130(1) have not been met the payment of $X is not an employment termination payment.

The payment is received no later than 12 months after termination

The second condition is stated under paragraph 82-130(1)(b) of the ITAA 1997. The payment must be received within 12 months of the employee's termination of employment, unless the payment is covered by a determination exempting them from the 12 month rule.

The proposed payments has not been made to your client. However the proposed payments will be made to your client no later than 12 months after termination of your client's employment, therefore, the requirement under paragraph 82-130(1)(b) of the ITAA 1997 will be satisfied.

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;

· unused annual leave or long service leave payments;

· foreign termination payments covered under Subdivision 83-D of the ITAA 1997; and

· the tax free part of a genuine redundancy payment or an early retirement scheme payment.

Relevant to this particular case is whether any part of payment A represents the tax free part of a genuine redundancy payment.

Genuine redundancy payment

A payment made to an employee is a genuine redundancy payment if it satisfies all the criteria set out in section 83-175 of the ITAA 1997.

Under subsection 83-175(1) of the ITAA 1997, four criteria must be satisfied:

· The payment must be received in consequence of a termination.

· That termination must involve an employee being dismissed from employment.

· That dismissal must be caused by the redundancy of the employee's position.

· The redundancy payment must be made genuinely because of a redundancy.

· Payment is made in consequence of the termination of employment

As explained earlier, it is evident that payment A made to your client was made in consequence of the termination of their employment. The termination of employment and payment A are intertwined and connected. If not for the termination of employment, payment A would not have been made.

Dismissal and Redundancy

The Explanatory Memorandum to the Income Tax Assessment Amendment Act (No.3) 1984 which inserted former section 27F, which dealt with bona fide redundancy payments, into the Income Tax Assessment Act 1936 (ITAA 1936) states at page 91:

The terms "dismissal" and "redundancy" are not defined in the legislation and, therefore, should be given their ordinary meanings. "Dismissal" carries with it the concept of the involuntary (on the taxpayer's part) termination of employment. "Redundancy" carries the concept that the requirements of the employer for employees to carry out work of a particular kind, or for employees to carry out work of a particular kind in the place where they were so employed, have ceased or diminished or are expected to cease or diminish. Redundancy, however, would not extend to the dismissal of an employee for personal or disciplinary reasons or for reasons that the employee was inefficient.'

Consequently, it is necessary to consider the ordinary meaning of the terms 'dismissal' and 'redundancy' and the meaning the judicial authorities have ascribed to them.

The Commissioner has issued Taxation Ruling TR 2009/2, titled Income Tax: genuine redundancy payments which provides guidance on the factors to be considered in the interpretation of section 83-175 of the ITAA 1997.

Paragraph 18 of TR 2009/2 discusses what constitutes a dismissal:

18. Dismissal is a particular mode of employment termination. It requires a decision to terminate employment at the employer's initiative without the consent of the employee. This stands in contrast to employment that is terminated at the initiative of the employee, for example in the case of resignation.

A payment is classified as a genuine redundancy payment only upon meeting all of the requirements set under section 83-175 of the ITAA 1997 and dismissal only forms part of those requirements.

Paragraphs 24, 25 and 28 of TR 2009/2 provide the following in relation to the meaning of redundancy:

24. As is the case in determining if there is a dismissal, the reason for a dismissal is to be established in light of the facts and circumstances of each case. The redundancy of the relevant position must be the prevailing or most influential reason for the dismissal if there is more than one contributing cause.

25. An employee's position is redundant when an employer determines that it is superfluous to the employer's needs and the employer does not want the position to be occupied by anyone. Accordingly, it is fundamentally the employer's decision that a position is redundant. On occasion the decision may be unavoidable due to the circumstances surrounding the employer's operations.

…

28. A dismissal is not caused by redundancy where personal acts or default are the prevailing or most influential cause for the termination. For example, a person may be dismissed due to unsatisfactory performance or behaviour.

Your client's position ceased to exist and the decision to terminate your client's employment was made by the Employer without their consent.

Further, it is considered that your client has been dismissed from their employment because their role with the Employer has been made genuinely redundant.

Therefore, subsection 83-175(1) of the ITAA 1997 has been satisfied.

Further conditions for a genuine redundancy payment

Subsection 83-175(2) of the ITAA 1997 sets out further criteria that must be satisfied for a payment to be regarded as a genuine redundancy payment.

The first condition requires that the taxpayer is dismissed before the earlier of the day the taxpayer turns 65 or the day they reach a particular age or completed a particular period of service that would have terminated the taxpayer's employment.

This condition is satisfied as your client was dismissed before they were 65 years of age.

The second condition requires that if the dismissal were not at arms length, that the payment does not exceed the amount that could be reasonably expected to be made if the dismissal were at arms length.

This condition is satisfied as payment A does not exceed the amount that could be reasonably expected of a dismissal made at arm's length.

The third condition is that at the time of dismissal, there was no arrangement between the employee and the employer, or between the employer and another person, to employ the employee after the dismissal.

This condition is satisfied as at the time of dismissal there was no arrangement between your client and the Employer or between the Employer and another person, to employ them after the dismissal.

A further requirement, as set out in subsection 83-175(3) of the ITAA 1997, is that no part of the payment was received by the employee in lieu of superannuation benefits to which the employee may have become entitled at the time the payment was received or at a later date.

In this case, this condition is satisfied as no part of payment A to be received by your client is in lieu of superannuation benefits.

In addition, subsection 83-175(4) of the ITAA 1997 provides that a payment is not a genuine redundancy payment if it is a payment mentioned in section 82-135 (apart from paragraph 82-135(e)).

In this case no part of payment A is excluded from being a genuine redundancy payment as mentioned in section 82-135 of the ITAA 1997.

Therefore, payment of A is a genuine redundancy payment under section 83-175 of the ITAA 1997.

Tax-free amount

Subsection 83-170(2) of the ITAA 1997 provides that so much of a genuine redundancy payment that does not exceed the amount worked out using the formula prescribed in subsection 83-170(3) is not assessable income and is not exempt income. Any amount in excess of the tax-free amount is taxed as an employment termination payment. The formula for working out the tax-free amount is:

Base amount + (Service amount × Years of service)

For the 2012-13 income year:

· Base amount means $8,806;

· Service amount means $4,404; and

· Years of service means the number of whole years in the period, or sum of periods, of employment to which the payment relates.

In this case the payment of $Y is below the tax-free amount of a genuine redundancy payment. Therefore, the entire amount of the payment is the tax-free part of a genuine redundancy payment. This tax-free amount is not assessable income and is not exempt income under subsection 83-170(2) of the ITAA 1997.

Consequently the payment of $Y is not required to be included in your client's income tax return for the subsequent income year.

As already discussed above, the payment of $X was not received by your client in consequence of the termination of their employment and, therefore, is not an employment termination payment. The payment of $X is made for underpayments of salary in respect of your client's employment with the Employer and is to be included in the subsequent income year as ordinary assessable income.

Issue 2

Summary of decision

Payment A has been calculated as a retiring amount for past services of your client due to the redundancy of their position. This amount is not considered an excessive payment. The Commissioner of Taxation allows a deduction for payment A to your client as reasonable.

In relation to payment B you have arbitrarily calculated that your client has been underpaid an amount per annum for a period. The remuneration arbitrarily calculated for your client's time is not considered to be duties that would be remunerated as a family member. Therefore, payment B is considered excessive and accordingly disallowed.

Detailed reasoning

Payments of pensions, gratuities or retiring allowances

Under section 25-50 of the ITAA 1997, deductions are allowed for pensions, gratuities or retiring allowances paid by a taxpayer during the income year to employees, past employees or their dependants.

However, you can deduct it only to the extent that it is made in good faith in consideration of the past services of the employee, or former employee, in any business that you carried on for the purposes of gaining or producing assessable income. You cannot deduct a payment under this section if you can deduct it under any other provision of this Act.

In your case the payments are made in consequence of prior service as an employee and the payments were made in good faith in consideration of the past services of the employee as part of business carried on for the purpose of producing assessable income. 

Section 109 of the ITAA 1936 operates so that excessive payments by a private company to shareholders, directors and associates are deemed to be dividends.

The operation of section 109 of the ITAA 1936 is dependant upon the Commissioner forming an opinion that a payment (or part thereof) of a retiring allowance is unreasonable. The Commissioner has laid down some principles as to how this opinion will be formed in Taxation Ruling IT 2621.

Paragraph 15 of IT 2621 states that other factors that may be relevant include

· the terms of employment;

· length of service;

· level of remuneration during the period of service;

· other benefits to which the retiree may be entitled;

· commercial practice; and

· advice sought as to the quantum of amount paid.

This list is not intended to be exhaustive.

In Tribunal Case 53⁵, the Administrative Appeals Tribunal, constituted by a Presidential Member (Purvis J), stated:

I am not compelled by the Income Tax Assessment Act to arrive at a mathematical calculation as to what the employees would have received if they were to be rewarded on a particular hourly rate or as an employee of a particular company. Comparative figures can be and are helpful. I am required to consider, having in mind all of the relevant circumstances in evidence, and in the context of the particular commercial venture in which the company was engaged and the principles already enunciated, whether the charge made by the company by way of wages was reasonable.

Terms of employment:

In your case your client was a family member.

Length of service:

Your client has been employed by the predecessor firms of the Employer for a period and the Employer since the Y income year.

Level of remuneration during the period of service:

You provided details that showed your client's average wage per annum.

Other benefits to which the retiree may be entitled:

There were other distributions of investment income to your client. Your client received no other substantial benefits other than superannuation contributions.

Commercial Practice

The payment is to be paid to compensate for past services.

Conclusion

Paragraph 13 of IT 2621 states that when forming an opinion under section 109 of the ITAA 1936 as to the reasonableness of an amount it is clear that all the circumstances of the case must be taken into account.

You have calculated payment A as a retiring amount for past services of your client due to the redundancy of their position based on section 83-170 of the ITAA 1997. This amount is not considered an excessive payment under section 109 of the ITAA 1936.

You have arbitrarily calculated your client to have been underpaid for a period. Reference has been made that in 20XX a level 4 employee would have been paid $Z per annum. This rate is based on the current Modern award, the award 20XX. This amount is based on a full time position.

Your client's duties and level of remuneration appears to be adequate remuneration considering their position with the Employer.

The remuneration arbitrarily calculated for your client's time is not considered to be duties that would be remunerated as a family member.

Therefore taking into account IT 2621 payment B is excessive and accordingly disallowed under section 109 of the ITAA 1936.

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