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Authorisation Number: 1011773046148

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Ruling

Subject: Employment termination payment

Question

Is the payment made by a company to a non-executive director on termination of office as a result of the sale of the company to a third party an employment termination payment under section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: Yes.

This ruling applies for the following period:

2010-11 income year

The scheme commences on:

1 July 2010

Relevant facts and circumstances

Your client served as a non-executive director and non executive chairman of Company A prior to the acquisition of Company A by Company B pursuant to a share agreement made between, among others Company B and Company A (Sale Agreement).

Your client commenced employment with Company A on a specific date during the 2002-03 income year.

The majority of the shares in Company A were, prior to it being sold to Company B pursuant to the Sale Agreement owned by funds and mandates managed by Company C.

Company C entered into an agreement with your client (Exit Incentive) during the income year ended 30 June 2010 whereby in the event of a sale of shares in Company A, your client would be entitled to an exit incentive, the amount of which was determined indirectly by the amount of sale proceeds received Company C, provided your client was still a director of Company A as at the time of the completion of the Sale Agreement.

The Exit Incentive did not contemplate the cessation of employment as a consequence of a potential sale although the parties did consider that it was highly likely that your client would cease to be a director as a condition of the sale of Company A to a third party.

During the sale negotiation with Company B it was evident that the sale of shares in Company A would be conducted on the condition that your client would resign as a non-executive director of Company A. It was also unlikely that any further employment opportunities with Company A would be offered to your client subsequent to the sale.

Your client therefore renegotiated at arm's length with Company C which resulted in the bonus agreement being rescinded and replaced by the agreement on a specific date during the 2010-11 income year in which Company A would pay the exit incentive.

On a specific date during the 2010-11 income year, the funds and mandates managed by Company C (as well as the other shareholders of Company A) entered into an agreement with Company B (among others) for the sale of all the ordinary shares in Company A to Company B, resulting in Company A becoming a wholly-owned subsidiary of Company B.

Under Clause X of the Sale Agreement, at or before Completion, the company must ensure a meeting of the directors of the Company is held at which it is resolved that, subject to Completion, the resignations of the existing directors, secretary and public officer of the Company be accepted.

The sale of the shares in Company A was completed on a specific date during the 2010-11 income year.

In accordance with clause X of the Sale Agreement your client tendered his resignation as a director on a specific date during the 2010-11 income year when the sale of shares in Company A to Company B was completed as all directors of Company A must resign and their resignations must be accepted by Company A on or before the completion of the acquisition of shares in Company A by Company B.

There are no non-executive directors serving on the Board of Company A after the sale of shares to Company B.

Your client also had a very minor shareholding in Company A prior to the sale of shares to Company B. These shares were offered to, and paid by, him when appointed chairman of the Board of Company A.

On a specific date during the 2010-11 income year you confirmed that the gross payment representing the exit incentive was made to your client by Company A on completion of the sale of shares to Company B. The amount of the gross payment was Amount A. An amount was withheld from the gross payment for income tax purposes and a further amount was retained in escrow to cover the possibility of a warranty claim against the former shareholders of Company. The net amount was paid to the client by way of cheque on a specific date during the 2010-11 income year.

Your client is over 65 years of age.

Relevant legislative provisions

Section 82-130 of the Income Tax Assessment Act 1997
Subsection 82-130(1) of the Income Tax Assessment Act 1997
Paragraph 82-130(1)(a) of the Income Tax Assessment Act 1997
Subparagraph 82-130(1)(a)(i) of the Income Tax Assessment Act 1997
Paragraph 82-130(1)(b) of the Income Tax Assessment Act 1997
Paragraph 82-130(1)(c) of the Income Tax Assessment Act 1997
Section 82-135 of the Income Tax Assessment Act 1997
Section 82-140 of the Income Tax Assessment Act 1997
Section 82-145 of the Income Tax Assessment Act 1997
Section 82-150 of the Income Tax Assessment Act 1997
Section 82-155 of the Income Tax Assessment Act 1997
Section 995-1 of the Income Tax Assessment Act 1936

Reasons for decision

Summary

The payment of Amount A made by Company A to your client as a result of the sale of the company to a third party is an employment termination payment as:

· it was made in consequence of the termination of your employment;

· it was received within 12 months of the termination of your employment; and

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

Detailed Reasoning

Employment termination payments made on or after 1 July 2007

From 1 July 2007, the taxation treatment of payments made in consequence of the termination of any employment of the taxpayer has changed. These payments were formerly known as eligible termination payments (ETPs).

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:

(d) 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

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

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

To determine whether the payment to be made by Company A to your client 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 three conditions will result in the payment not being considered an employment termination payment. Furthermore, any termination payments received outside of the 12 months will be 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 your 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 Taxation Ruling TR 2003/13 the Commissioner has considered the 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 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).

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 my opinion necessary that the termination of the services should be the dominant cause of the payment.

While in the same case 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] FCA 1258; (2002) 124 FCR 53; (2002) 195 ALR 194; (2002) 2002 ATC 4907; (2002) 51 ATR 39 (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 taxpayers dismissal was an ETP.

Justice Goldberg stated:

I am satisfied that there is a sufficient connection between the termination of the applicants employment and the payment to warrant the finding that the payment was made in consequence of the termination of the applicants 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.

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 Taxation [2004] FCAFC 126; (2004) 207 ALR 151; (2004) 2004 ATC 4555; (2004) 55 ATR 786 (Dibb), 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.

In 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 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. Hence, the payment will be an employment termination payment unless the payment is specifically excluded under section 82-135 of the ITAA 1997.

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.

From the facts of the case, your client served as a non-executive director of Company A prior to the acquisition of Company A by Company B pursuant to a share agreement made between, among others, Company B and Company A (Sale Agreement). As agreed by the parties to the Sale Agreement, clause X of the Sale Agreement specified that all directors of Company A must resign and their resignations must be accepted by Company A on or before the completion of the acquisition of shares in Company A by Company B. The sale of the shares in Company A was completed on a specific date during the 2010-11 income year. Your client terminated employment with Company A on a specific date during the 2010-11 income year.

It is evident from the foregoing that the termination of employment was a precondition to the making of the payment. The termination of employment and the payment is all intertwined and connected. Your client would not have otherwise received the payments except for the termination of his employment. The circumstances in which the payment was made clearly show that the payment was made in consequence of termination of employment and is an employment termination payment. Therefore, the first requirement under subparagraph 82-130(1)(a)(i) of the ITAA 1997 has been satisfied.

The payment is received no later than 12 months after termination

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

You client terminated employment with Company A on a specific date during the 2010-11 income year and the lump sum was paid on a specific date during the 2010-11 income year. The payment was made within 12 months of the termination of your client's employment. Therefore the requirement under subparagraph 82-130(1)(b) of the ITAA 1997 has been satisfied.

The final requirement under paragraph 82-130(1)(c) of the ITAA 1997 is that the payment is not a payment mentioned in section 82-135.

Exclusions under section 82-135 of the ITAA 1997

As already noted, certain payments made on termination of employment are excluded from being an employment termination payment under section 82-135 of the ITAA 1997.

No portion of the payment qualifies as any of the payments listed in paragraphs 82-135(a) to (m) of the ITAA 1997.

Therefore, the payment made to your client does not fall within any of the exclusions contained in section 82-135 of the ITAA 1997.

Accordingly, as all the conditions in section 82-130 of the ITAA 1997 are satisfied, the payment made by Company A to your client is an employment termination payment under section 82-130 of the ITAA 1997.

Tax Treatment of the employment termination payment

An employment termination payment made after 1 July 2007 will be comprised of the following components:

· Tax free component this includes the pre-July 83 segment (if any) and/or the invalidity segment (if any); and

· 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.

Your client commenced employment with Company A on a specific date during the 2002-03 income year as a non-executive director and non-executive chairman. Your client terminated employment with Company A in the 2011 income year. Therefore, there will not be any pre-July 83 segment within the meaning of section 82-155 of the ITAA 1997.

As the payment is not made because your client ceased being gainfully employed as a result of suffering from ill-health, there is no invalidity segment for the purposes of section 82-150 of the ITAA 1997.

As the employment termination payment of Amount A contains neither a pre-July 83 segment nor an invalidity segment, there is no tax free component as defined in section 82-140 of the ITAA 1997. Rather the entire employment termination payment is a taxable component as defined in section 82-145 of the ITAA 1997.

The taxable component is subject to tax, depending on the person's age when the payment is received.

For recipients below preservation age, the taxable component of an employment termination payment is taxed at 30% for amounts below the employment termination payments cap of $160,000 for the 2010-11 income year, and at the top marginal rate for amounts above the cap.

For recipients above preservation age, the taxable component of an employment termination payment is taxed at 15% for amounts below the employment termination payments cap of $160,000 for the 2010-11 income year, and at the top marginal rate for amounts above the cap.

Preservation age is the age at which retirees can access their superannuation benefits. This will be 55 for persons born before 1 July 1960 and between 55 and 60 for persons born after 30 June 1960.

In this case, your client was over preservation age on the last day of the income year in which the payment of Amount A was made. As your client was over preservation age, the amount of the payment up to $160,000 is taxed at a maximum rate of 15%. The amount of Amount B (the amount over $160,000) is taxed at the top marginal tax rate plus Medicare levy.

Your client should include Amount A in his income tax return for the 2010-11 income year.