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Ruling

Subject: Employment termination payments

Question:

If an agreed settlement amount in relation to a termination of employment is paid in instalments under the terms of a Deed of Release, will the instalment amounts be considered employment termination payments (ETPs)?

Advice/Answer:

Yes. However, any payments made later than 12 months after the same termination of employment are not ETPs.

This ruling applies for the following period:

1 July 2010 to 30 June 2012

The scheme commenced on:

1 July 2010

Relevant facts:

An individual (Individual 1) was appointed as a director of an entity (Entity 1) in July 19XX.

Another individual (Individual 2) was appointed as a director of Entity 1 in October 200X. He also acted as the Chief Executive Officer.

No formal employment agreement was entered into between Individual 2 and Entity 1, however Individual 2 was paid a salary.

In September 200Y, another entity (Entity 2) was incorporated in an overseas country and Individual 1 was the sole stockholder.

Individual 1 and Individual 2 were also appointed as directors of Entity 2.

On a particular day in 2010 (the termination date), pursuant to a resolution of members (First Resolution) Individual 2 was removed as a director of Entity 1, effective immediately.

In the following month 2010, pursuant to a resolution (Second Resolution) of the sole stockholder of Entity 2 (Individual 1), Individual 2 was removed as director of Entity 2, effective immediately.

Individual 1 has continued to be the sole director of Entity 1 and the sole director of Entity 2.

A third entity (Entity 3) is the owner of XXX shares in Entity 1 including YY fully paid shares that were redeemed and reissued to Entity 3, pursuant to the First Resolution of 2010.

As a result, Entity 3 is now the sole shareholder of Entity 1 and Individual 1 is Entity 3's sole director and sole shareholder.

Following Individual 2's termination, an agreement was reached for a payment in lieu of notice. This notice payment ($A) was paid to Individual 2 in June 2010 together with amounts which were his entitlement for unused annual leave and unused long service leave.

Soon after, Individual 2 commenced legal proceedings asserting an entitlement to be issued shares in Entity 1.

Individual 2 also disputed the validity of the resolution (First Resolution) terminating his directorship and employment based on the assertion that he should have been given notice of the First Resolution as though he were on the shareholders' register.

In order to finalise its association with Individual 2, the parties (Individual 1, Individual 2, Entity 1, Entity 2 and Entity 3) reached an agreement to settle all claims arising out of Individual 1's employment.

A Deed of Release was executed in late 2010 by the parties.

In consideration for payment of $B (settlement amount as per Schedule A in the Deed of Release), Individual 1 agreed that he has no further claim in relation to his termination or the issue of shares in Entity 1.

Schedule A shows the settlement amount is to be paid as $C on a date in December  2010 followed by 18 monthly instalments of $X commencing in January 2011 and ending in June 2012.

As at March 2011, the first amount of $C plus three monthly instalments of $X as per Schedule A of the Deed of Release have been paid to Individual 2.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 82-10

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)(b)

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

Income Tax Assessment Act 1997 Section 82-130(4)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Section 82-170

Income Tax Assessment Act 1997 Subsection 82-160

Income Tax Assessment Act 1997 Section 83-295

Reasons for decision

Summary

The initial amount of $C and all instalment amounts paid up to the date in May 2011 (the date that was 12 months after the termination date) pursuant to the Deed of Release are employment termination payments (ETPs).

The instalment amounts paid after the May 2011 date are not subject to concessional tax treatment and are to be taxed at marginal rates in the relevant income year the amounts are received.

Detailed reasoning

Employment termination payment

A payment made to an employee is an employment termination payment if the payment satisfies all the requirements in section 82-130 of the ITAA 1997 and is not specifically excluded under section 82-135.

Subsection 82-130(1) states:

A payment is an employment termination payment if:

(a) it is received by you:

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

(ii) after another 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 the termination (but see subsection (4)); and

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

Subsection 82-130(2) states:

A life benefit termination payment is an employment termination payment to which subparagraph (1)(a)(i) applies.

In Taxation Ruling 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), the Commissioner considered the meaning of the phrase 'in consequence of' as interpreted by the Courts.

In paragraphs  5 and 6 of TR 2003/13 the Commissioner states:

5. The phrase 'in consequence of' is not defined in the ITAA 1936. However, the words have been interpreted by the courts in several cases. Whilst there are divergent views as to the correct interpretation of the phrase, the Commissioner considers that 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.

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

Therefore, if the payment follows on 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.

Individual 2 (the former employee) gave notice in writing asserting an entitlement to be issued shares in Entity 1 by disputing the validity of the First Resolution terminating his directorship and employment with Entity 1. This was based on his assertion that he should have been given notice of the First Resolution as though he were on the shareholders' register.

Individual 2 and Entity 1 were parties to an agreement which was to provide for settlement of the dispute by the Deed of Release effected in late 2010.

As parties to the agreement, both agreed the settlement amount of $B was to be paid by way of instalments and to be made on the dates as set out in Schedule A to the Deed of Release.

Although the dominant cause of the payment was to settle the claim initiated by your former employee, there is a causal connection between the termination of employment and the agreed settlement payment. This is clear from the settlement terms as set out in the Deed of Release.

Given the nature of the dispute, it is reasonable to state that the parties would not have entered into the Deed of Release if employment had not ceased. Accordingly, the dispute, the settlement, the termination of employment and the instalment payments are all intertwined and connected.

The essence of the preceding discussion is that while a payment may be made for a number of reasons, if the payment is connected or linked to the termination of employment, it will be paid in consequence of the termination of employment and is an employment termination payment (ETP) as defined in section 82-130 of the ITAA 1997.

Based on the information provided, the agreed settlement amount made pursuant to the terms as set out in the Deed of Release, will be made in consequence of the termination of employment because there is a nexus between the agreed settlement amount and the termination of employment on the termination date in May 2010.

Further, the payment will be a life benefit termination payment unless the payment is specifically excluded under section 82-135 of the ITAA 1997. For example, amounts received for unused annual leave and unused long service leave are excluded from being ETPs.

However, paragraph 82-130(b) of the ITAA 1997 also requires an ETP to be received no later than 12 months after a person's termination of employment (referred to as the 12-month rule).

A termination payment that fails the 12-month rule is therefore not assessable as an ETP and does not receive concessional tax treatment. Instead, the termination payment is assessable income in accordance with section 83-295 of the ITAA 1997 and taxed at ordinary marginal rates without entitlement to a tax offset on the amount.

Tax payable on life benefit termination payments

A life benefit termination payment is an ETP received in consequence of termination of employment.

The extent of the entitlement to the tax-offset on life benefit termination payments depends on:

· a person's age in the year they receive the tax offset,

· the total amount of the life benefit termination payments received in the same year, and

· the total amount of life benefit termination payments received in consequence of the same employment termination (whether they are received in the same year or in an earlier income year).

Individuals who are below their preservation age throughout the 2009-10 year will pay no more than 30% (plus Medicare levy) on the total amount of the life benefit termination payments that is within the ETP cap amount of $150,000. Tax is payable at the top marginal rate (plus Medicare levy) on amounts in excess of the ETP cap amount. For the 2009-11 income year the ETP cap amount is $160,000.

The ETP cap amount in relation to the relevant income year when payments are received is reduced by the amount of all previous payments that counted towards the ETP cap amount regardless of when the previous payments were made if they are in consequence of the same employment termination.

From the information provided, the payment in lieu of notice $A received in June 2010 (in the 2009-10 income year) and the total amounts paid pursuant to the Deed of Release during the period from late 2010 to May 2011 (in the 2010-11 income year) are payments made in consequence of the same employment termination which occurred in May 2010.

Accordingly, these amounts are subject to concessional tax treatment (entitlement to a tax offset) as life benefit termination payments under section 82-10 of the ITAA 1997.

However, the limits imposed by subsection 82-10(4) will apply to the total amount of life benefit termination payments received up to the date in May 2011(the date that was 12 months after the termination date).

This means the notice payment of $A paid in the 2009-10 income year and the instalment payments for the period up to the date in May 2011 are added together and counted towards the ETP cap amount for each relevant income year the payments are received. This is because they are in consequence of the same employment termination.

Any instalment payments made after that date in May 2011 are not ETPs and are not subject to concessional tax treatment as the payments are not made within 12 months of termination of employment. As such, the amounts fail the 12-month rule in paragraph 82-130(b) of the ITAA 1997 which require amounts to be received no later than 12 months after the termination date.

As the amounts are not ETPs, they will be included as assessable income in the relevant income year the amounts are received and taxed at the person's relevant marginal rate.

Accordingly, the total instalments paid during the 2011-12 income year are not ETPs and included as assessable income and subject to the relevant marginal rate of tax for the income year.