Edited version of private ruling

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Ruling

Subject: Employment termination payment

Is the payment made to your client under an out of court settlement agreement, an employment termination payment in accordance with subsection 82-130(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes.

This ruling applies for the following period

Year ending 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

Your client entered into a contract a few years ago with their employer (the Employer).

Subsequently a new contract was entered into between your client and the Employer.

A series of events resulted in a dispute between your client and the Employer.

In the 2009-10 income year your client was advised that with immediate effect they were dismissed from their job for breach of contract. The employer stated that the termination of your client's employment was due to their refusal to comply with a reasonable direction.

Your client brought court action against their employer (the Proceeding) in a statement of claim where they claimed for damages in relation to their dismissal.

An out of court settlement agreement (the Settlement Agreement) was made in the 2009-10 income year between your client and the Employer for unfair dismissal.

The Settlement Agreement is made in full and final settlement of any and all claims against the Employer.

A pay advice from the Employer shows that a termination payment was made to your client in the 2009-10 income year.

The settlement payment was made to your client within 12 months after the termination of their employment.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 27A

Income Tax Assessment Act 1936 Subsection 27A(1)

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 Paragraph 82-130(1)(b)

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

Income Tax Assessment Act 1997 Paragraph 82-130(4)(a)

Income Tax Assessment Act 1997 Subsection 82-130(5)

Income Tax Assessment Act 1997 Subsection 82-130(7)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Subsection 82-135(1)

Income Tax Assessment Act 1997 Section 83-295

Income Tax Assessment Act 1997 Subdivision 118-A

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 118-22

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary:

The settlement payment is an employment termination payment as:

· it was made in consequence of the termination of your client's employment

· it was received within 12 months of the your client's termination of employment

· it is not payment which is excluded from being an employment termination payment.

Detailed reasoning:

Employment termination payment

Section 995-1 of the 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 the payment made to your client under an out of court settlement agreement (the Settlement Agreement) constitutes 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 the payment not being considered an employment termination payment. Furthermore, any termination payments received outside of the 12 month period are taxed as ordinary income at marginal tax rates, unless the taxpayer is covered by a determination exempting them from the 12 month rule.

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 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of' (TR 2003/13).

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 Taxation (1975) 133 CLR 45; 75 ATC 4213; (1975) 5 ATR 538 (Reseck) and the Full Federal Court in McIntosh v. Federal Commissioner of Taxation 79 ATC 4325; (1979) 10 ATR 13 (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 Taxation (2002) 124 FCR 53; 2002 ATC 4907; (2002) 51 ATR 139 (Le Grand), the issue before the 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. FC of T 2004 ATC 4555; (2004) 55 ATR 786, 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.

In the facts of this case, your client entered into a contract a few years ago with their employer (the Employer).

Subsequently a new contract was entered into between your client and the Employer.

A series of events resulted in a dispute between your client and the Employer.

In the 2009-10 income year your client was advised that with immediate effect they were dismissed from their job for breach of contract. The Employer stated that the termination of your client's employment was due to their refusal to comply with a reasonable direction.

Your client brought Court action against their employer (the Proceeding) in a statement of claim where they claimed for damages in relation to their dismissal.

An out of court settlement agreement (the Settlement Agreement) was made in the 2009-10 income year between your client and the Employer for unfair dismissal.

The Settlement Agreement is made in full and final settlement of any and all claims against the Employer.

A pay advice from the Employer shows that a termination payment was made to your client in the 2009-10 income year.

From the above it is clear that, while payment was being made for a number of reasons, one of those reasons was the termination of your client's employment.

Consequently, it is considered that the settlement payment was made in consequence of the termination of your client's employment. The termination of employment, the Settlement Agreement and the settlement payment are all intertwined and connected.

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

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 settlement sum 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 settlement payment was made to your client within 12 months after the termination of their employment. Therefore, the requirement of paragraph 82-130(1)(b) of the ITAA 1997 has been satisfied.

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

Certain payments made on termination of employment are excluded from being an employment termination payment under section 82-135 of the ITAA 1997. These payments include any accrued annual and long service leave, the tax-free parts of a genuine redundancy payment or an early retirement scheme payment as well as other types of payments which do not apply to your client's settlement payment.

Prior to 1 July 2007 a payment made on termination of employment was excluded from being a eligible termination payment (ETP) under former subsection 27A(1) of the Income Tax Assessment Act 1936 (ITAA 1936) if it was covered by the exemption for personal injury under paragraph (n) of the definition of an 'eligible termination payment' under former subsection 27A(1).

Similarly, under section 82-130(1) of the ITAA 1997 consideration must be given to whether the specific exemption for personal injury in paragraph 82-135(i) of the ITAA 1997 (payments that are not employment termination payments) applies. This subsection states that employment termination payments do not include:

(i) a capital payment for, or in respect of, personal injury to you so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on your capacity to derive income from personal exertion (within the meaning of the definition of income derived from personal exertion in subsection 6(1) of the Income Tax Assessment Act 1936);

This exclusion is for a payment or benefit that compensates or reimburses a person for or in respect of the particular injury.

In Federal Commissioner of Taxation v. Scully (2000) 201 CLR 148; 2000 ATC 4111; (2000) 43 ATR 718 the High Court held that compensation must be calculated by reference to the nature and extent of the injury or likely loss to the taxpayer. The payment in this case was not in respect of personal injury, acting Chief Justice Gaudron and Justices McHugh, Gummow and Callinan stating in their joint decision:

41. In our opinion, the payment in this case cannot be characterised as consideration... in respect of, personal injury. The fact that the payment is not calculated by reference to the nature and extent of the injury or likely loss to the respondent and the fact that the other benefits are similar to that for total and permanent disablement point inevitably to the conclusion that the payment was consideration... for, or in respect of the respondent's termination of employment and her rights under the Trust Deed and was not consideration... for, or in respect of her injury.

In the Administrative Appeals Tribunal (AAT) decision AAT Case 20/97 (1997) 97 ATC 258; Case 11,722 (1997) 35 ATR 1114 a taxpayer negotiated a settlement with their past employer by agreeing to a certain amount and that they would accept to forgo all past, present and future claims against the employer, except for personal injury. Senior Member Dwyer ruled that, given the 'exception' in the settlement clause, no amount of the settlement could be for personal injury, therefore the ETP exclusion provisions could not apply to the amount.

There are three types of injury that a person can receive:-

· behavioural injury - one that involves physical injury (internal and/or external) and/or mental illness that is clearly discernible to a qualified medical practitioner;

· non-behavioural injury - hurt, distress, anxiety, and so on, that flows from the death of, or serious injury to, a relative or close friend; wrongful dismissal; defamation and so on. This type of injury may have legal remedies under the law of torts (for example, defamation, slander), statute (for example, sexual harassment, discrimination), or contract (for example, employment, professional negligence), and

· property injury - damage to a persons property.

Notwithstanding it may be said that all three types of injury may be personal, it is considered that only the first type (that is, behavioural injury) falls within the meaning of the term personal injury.

The reasoning above is based on the decision by the Victorian Supreme Court in Graham v. Robinson [1992] 1 VR 279 (Graham v. Robinson) where the Court had to decide if emotional hurt (that is, hurt, distress, public scandal, hatred, odium, ridicule and contempt) was a personal injury. At 281, Justice Smith stated:

In the absence of express authority, I have come to the conclusion that the expression personal injury does not extend beyond physical injury and mental illness to include emotional hurt. I am encouraged to this view by the fact that the law has rejected grief or sorrow as a form of injury which can be relied on to mount a claim in negligence: Mount Isa Mines Ltd. v. Pusey (1970) 125 CLR 383, at p. 394 and Jaensch v. Coffey (1984) 155 CLR 549, at p. 587. It is true that damages are awarded for pain and suffering in the typical personal injury case. They are awarded, however, where pain and suffering flow from and are connected with physical or mental injury and may therefore be said to be damages in respect of personal injury.

The decision in Graham v. Robinson was applied in the AAT decision McMahon v. FC of T 99 ATC 2025; (1999) 41 ATR 1056 (McMahon) in relation to a payment for alleged damage to a taxpayer's reputation. In McMahon, a critical performance appraisal of the taxpayer and other comments were published in the media. Subsequent to this, the taxpayer's employment was terminated and it was agreed to pay him certain amounts including an amount for the alleged damage to his reputation. Senior Member Block stated:

26 The tribunal also notes the stipulation in the concluding portion of s 27A(1)(n) of the Act that the amount of consideration for personal injury is to be regarded as an ETP only to the extent that it is reasonable having regard to the nature of the injury and the taxpayers capacity to derive income from personal exertion. The tribunal considers that the inclusion by the legislature of the words from personal exertion tends to confirm that the section is intended to exclude from the definition of ETP payments in respect of injuries to the person, where such injuries being physical injuries or mental illnesses which have an assessable and identifiable impact on the capacity of the taxpayer to earn income. The tribunal considers in summary that an injury to person is distinguishable from an injury to a persons reputation.

27 For the Reasons set out previously (and bearing in mind that the decision in Graham v. Robinson is binding on the tribunal), the reputation payment was not made in respect of personal injury within s27A(1)(n) of the Act which does not operate to exclude it from the provisions of s. 27A of the Act; accordingly the reputation payment was correctly assessable as an ETP.

To reiterate, there must be a 'behavioural' type personal injury. From the above case, the term 'personal injury' is limited to physical and/or mental injury.

The settlement payment is, amongst other things, a capital sum for damages for emotional upset and damage to reputation. Therefore, for the purposes of paragraph 82-135(i) of the ITAA 1997 (and former paragraph (n) of the definition of an 'eligible termination payment' under former subsection 27A(1) of the ITAA 1936) the settlement payment could not be said to be in respect of personal injury.

Hence, it is considered that paragraph 82-135(i) of the ITAA 1997 does not apply to the settlement payment of made to your client.

Therefore, the settlement payment is not of a type that paragraph 82-130(1)(c) of the ITAA 1997 would exclude from being an employment termination payment.

As all the conditions in section 82-130 of the ITAA 1997 have been satisfied, the settlement payment of is considered to be an employment termination payment.

Exemption for personal injury

The general capital gains tax (CGT) exemption provisions are found in Subdivision 118-A of the ITAA 1997. Included amongst them is an anti-overlap provision, section 118-20, which ensures that an amount cannot be assessable under both the CGT provisions and any other non-CGT provision. The effect of section 118-20 is to reduce the amount of any assessable capital gain by any amount which is also assessable under a non-CGT provision of either the ITAA 1997 or the ITAA 1936 and by amounts which are exempt income.

Section 118-22 of the ITAA 1997 operates to ensure that an employment termination payment that a person receives is considered to have been included in their assessable income for the purposes of section 118-20 of the ITAA 1997.

Consequently, as the settlement payment your client received is considered to be an employment termination payment, the CGT provisions will not apply to the settlement payment.

Tax Treatment of the payment as a Life Benefit Termination Payment (LBTP):

An employment termination payment will comprise of the following components:

1. Tax free component - this includes the pre-July 83 segment (if any) and/or the invalidity segment (if any), and

2. Taxable component - the amount remaining after deducting the tax free component from the total payment.

The tax free component is not assessable income and is not exempt income. The taxable component is included, in full, as assessable income of the recipient.

Employment termination payments cannot be rolled over into a complying superannuation fund or to a retirement savings account (RSA) provider.