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Authorisation Number: 1011773621949

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Ruling

Subject: Employment termination payment

Questions

1) 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)?

2) Is any part of the payment received on termination of employment exempt from tax as a genuine redundancy payment under section 83-175 of the ITAA 1997?

Answers

1) Yes.

2) 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 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 during the 2004-05 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.

On behalf of the funds and mandates it manages, 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 by 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Your client therefore renegotiated at arm's length with Company C which resulted in the agreement being rescinded and replaced by the agreement dated on a specific date during the 2010-11 income year in which Company A would pay the exit incentive.

During a specific date in 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.

On a specific date during the 2010-11 income year you confirmed the gross payment 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 A. The net amount was paid to your client by way of cheque on a specific date during the 2010-11 income year.

Your client's dismissal from his employment was at arm's length.

There was no arrangement whereby your client would be re-employed by Company A, Company B or any other associated entities.

The payment is not made in lieu of a superannuation benefit.

Your client is under 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
Section 83-175 of the Income Tax Assessment Act 1997
Subsection 83-175(1) of the Income Tax Assessment Act 1997
Subsection 83-175(2) of the Income Tax Assessment Act 1997
Subsection 83-175(2) of the Income Tax Assessment Act 1997

Reasons for decision

Summary

Amount B received on termination of employment is exempt from tax as the tax-free amount of a genuine redundancy payment under section 83-175 of the ITAA 1997. Amount B is not assessable income and is not exempt income. The amount in excess of the tax free amount (Amount C) is taxed as 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. As a result, 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 payments. 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 settlement sum 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 during the 2010-11 income year. Therefore 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. Relevant to this particular case is whether any part of the payment is a genuine redundancy payment under paragraph (e) of section 82-135 of the ITAA 1997.

Genuine redundancy payment

A genuine redundancy payment is so much of a payment, received by an employee who is dismissed from employment because the employee's position is genuinely redundant. The payment must exceed the amount that could reasonably be expected to be received by the employee in consequence of the voluntary termination of his or her employment, at the time of the dismissal (subsection 83-175(1) of the ITAA 1997). Section 83-175 of the ITAA 1997 replaces former section 27F of the Income Tax Assessment Act 1936 (ITAA 1936) where the payment was referred to as a bona fide redundancy payment.

To qualify as a genuine redundancy payment all of the conditions under section 83-175(2) of the ITAA  1997 must be met. The conditions include:

· The employee is dismissed before the earlier of:

- the day he or she turned 65; or

- if the employee's employment would have terminated when he or she reached a particular age or completed a particular period of service the day he or she would reach the age or complete the period of service (as applicable).

· if the dismissal was not at arm's length the payment must not exceed the amount that could reasonably be expected to be made if the dismissal was at arm's length.

· at the time of the 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.

However, a genuine redundancy payment does not include any part of a payment that was received by the employee in lieu of superannuation benefits to which the employee may have become entitled at the time of the payment or at a later time.

Dismissal and redundancy

The first condition is that the taxpayer is dismissed from employment because the taxpayer's position is genuinely redundant.

The Explanatory Memorandum to the Income Tax Assessment Amendment Act (No.3) 1984, which inserted former section 27F into the 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.

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

Paragraph 11 of TR 2009/2 states:

There are four necessary components within the basis genuine redundancy requirement:

· The payment being tested 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.

Each of the requirements will be discussed individually.

The payment is in consequence of the termination of employment

The issue of whether the payment was made in consequence of your termination of employment was discussed above. It was determined that the payment was made in consequence the termination of your client's employment. Therefore the requirement that the payment must be received in consequence of a termination has been met.

Dismissal from employment

Dismissal carries with it the concept that the termination of a person's employment is normally involuntary and instigated by the employer. Consequently, resignation by the employee would not, ordinarily, be considered a dismissal.

Dismissal however, can include the notion of constructive dismissal where an employee is placed in a situation where he or she has little option but to tender his or her resignation. It should be noted that constructive dismissal, as with other forms of dismissal, does not in its own right indicate that a genuine redundancy has taken place.

Your client was not dismissed from employment by the employer in any ordinary sense. Your client resigned from employment with Company A on a specific date during the 2010-11 income year. From the facts of the case, 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 as specified by clause X of the Sale Agreement.

It is accepted that the termination was a constructive dismissal as the manner in which the termination came about left your client with little other option. It was a condition of the Sale Agreement (under clause X of the Sale Agreement) for the acquisition of Company A by Company B that the directors resign before completion of the sale.

As your client was dismissed from employment by the employer, which includes constructive dismissal, the second requirement of a genuine redundancy has been met.

Dismissal caused by redundancy

Section 83-175 of the ITAA 1997 requires that the dismissal be caused by redundancy of the employee's position, and not for some other reason. Redundancy must be the reason for termination of employment by way of dismissal.

At paragraphs 25 to 29 of TR 2009/2, the Commissioner makes the following comments regarding dismissal and redundancy:

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 of the employer's operations.

26. In some circumstances, an employer may reallocate the duties and functions attached to a particular position to another position within the employer's organisational structure. In such cases, the former position is redundant. However, if the employee who had been working in that position is still employed by the employer following the reallocation of duties and functions, there will not be a dismissal.

27. On the other hand, if an employer decides after a structural reorganisation to terminate an employee, the former position of the employee is effectively redundant as long as the reorganisation is the prevailing or most influential cause of the termination.

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.

29. In some cases, an employer may decide to reorganise or restructure their organisation at the same time as identifying underperformance of particular members of staff or areas within the existing organisational structure. In the event that employees are dismissed in these circumstances, careful consideration will need to be given to what was the prevailing or most influential cause of dismissal.

In this case, the position of director for Company A is redundant as the directors had to resign under clause X of the Sale Agreement at or before completion of the sale and there are no non-executive directors serving on Company A after the sale of shares to Company B.

As it is considered that the dismissal was caused by the redundancy of your client's position, the third requirement of a genuine redundancy has been satisfied.

The redundancy payment must be made genuinely because of a redundancy

Paragraph 277 of TR 2009/2 states:

Whether a redundancy payment is genuine is to be determined on an objective basis. It is not sufficient that an employer and employee have an understanding that a payment is a redundancy payment or that the employer calls the payment a redundancy payment to give the employee a better taxation outcome. The nature of the termination of an employee does not depend on what was communicated to that employee in relation to the termination.

The need for the employees position to be genuinely redundant establishes that contrived cases of redundancy will not meet the conditions in section 83-175 of the ITAA 1997.

In the present case there is nothing to indicate that the redundancy is not genuine. Therefore the fourth requirement of a genuine redundancy payment 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 from his role before he was 65 years of age.

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

This condition does not apply as the dismissal was 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 (written, verbal or implied) between your client and the employer or between the employer and another person, to employ your client after the dismissal and the agreement to reemploy your client arises after the termination of your client's employment.

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 the payment was received by your client in lieu of superannuation benefits.

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

As mentioned above, 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)).

This condition is satisfied as the payment is not a payment mentioned in section 82-135 of the ITAA 1997 (apart from paragraph 82-135(e)).

Tax-free amount of genuine redundancy payment

So much of the genuine redundancy payment that does not exceed the amount worked out using the prescribed formula is not assessable income and is not exempt income. The formula for working out the tax-free amount is:

Base amount + (Service amount x Years of service)

For the 2010-11 income year:

Base amount means $8,126

Service amount means $4,064 and

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

Your client commenced employment with Company A on a specific date during the 2004-05 income year. Your client had completed a number of years of service at the time of the termination of his employment. Therefore, the tax-free amount determined under subsection 83-170(3) of the ITAA 1997 is:

= $8,126 + [$4,064 x number of completed years of service]

= Amount B

Therefore, Amount B is the tax free amount which is not assessable income and is not exempt income under subsection 83-170(2) of the ITAA 1997.

Amount C (that is Amount A less Amount B) is an employment termination payment.

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 the employer on a specified date during the 2004-05 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 C 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 your case, your client was over preservation age on the last day of the income year in which the payment Amount C 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%. Amount D (the amount over $160,000) is taxed at the top marginal tax rate plus Medicare levy.

Conclusion

In this case all the conditions in section 83-175 of the ITAA 1997 have been satisfied and the payment made to your client is a genuine redundancy payment. The tax free amount of the redundancy payment is Amount B. The payment in excess of Amount B is assessed as an employment termination payment. The amount of the employment termination payment up to $160,00 is taxed at a maximum rate of 15%. The amount of Amount D (the amount over $160,000) is taxed at the top marginal tax rate plus Medicare levy.

Amount C should be included in your client's income tax return for the 2010-11 income year.