Edited version of your private ruling

Authorisation Number: 1012461499492

Ruling

Subject: Genuine redundancy payment

Questions

1. Can the Company as an employer pay a genuine redundancy payment to Director A?

2. Can the Company as an employer pay a genuine redundancy payment to Director B?

3. If the answer in question 1 and 2 is 'yes', will it reduce the amount of personal services income attributed to Director B?

Answers

1. Yes

2. Yes

3. No

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The private company (the Company) incorporated a number of years ago.

The directors and employees of the Company are Director A and Director B.

The Company specialises in specific field.

There are two main entities in the specific field who have used contractors to provide maintenance function and solutions to their specific problems. Recently, these entities have taken their maintenance function in-house.

In the 2012-13 income year, Director B on behalf of the Company completed a long term contract for a sole client. On completion of the contract a renewal or a new contract was not available.

As a result of the above, the Company has lost their client base.

The Company has only obtained a small number of short contracts since the completion of the previous long term contract.

The outlook for more new contracts to the Company is not good. The Directors consider they have no alternative but to wind up the Company.

In a recent telephone conversation, Director B advised that they intend to wind up the Company in the next 12 months.

Director B advised that there are earnings by the Company in the 2012-13 income year.

These earnings are personal services income of Director B,

In a recent telephone conversation Director B advised that both Directors had received wages as employees from the Company. Since the personal services income rules applies to them, both Directors no longer received wages from the Company. Director B personally declares all earnings from the Company as personal services income in their individual income tax return.

The Company intends to pay a redundancy payment to both Directors equivalent to the tax-free limit in the 2012-13 income year.

Both Directors are under 65 years of age in the 2012-13 income year.

Director A does not perform principal work for the business.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 80-5

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 paragraph 82-130(1)(c)

Income tax Assessment Act 1997 Section 82-135

Income tax Assessment Act 1997 Subsection 83-175

Income tax Assessment Act 1997 Subsection 82-175(1)

Income tax Assessment Act 1997 Subsection 82-175(2)

Income tax Assessment Act 1997 Subsection 82-175(3)

Income tax Assessment Act 1997 subsection 83-170(2)

Income tax Assessment Act 1997 Subsection 83-170(3)

Income tax Assessment Act 1997 Section 85-20

Income tax Assessment Act 1997 Subsection 86-5(2)

Income tax Assessment Act 1997 Section 86-60

Income tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

The termination payment to be made to the employees is considered to be a genuine redundancy payment (GRP). If the termination payment is within the tax-free amount of a GRP, it is not assessable income and is not exempt income. Therefore, no part of the payment is required to be included in the individual's income tax return for the 2012-13 income year.

The Company cannot reduce the amount of personal services income (PSI) attributed to Director B by the amount of any redundancy payment paid to its employees.

Detailed reasoning

Employment termination payment

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 Income Tax Assessment Act 1997 (ITAA 1997)).

Section 995-1 of the ITAA 1997 states:

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

Subsection 82-130(1) of the ITAA 1997 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.

Therefore, it can be seen that a number of conditions need to be satisfied in order for the payment to be treated as an employment termination payment.

To determine if the payments are 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.

Payment is made in consequence of the termination of employment

The first condition to be met is that the payment is received by the person in consequence of the termination of their employment.

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the words have been interpreted by the courts in several cases. The Commissioner has also issued 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) which discusses the meaning of the phrase.

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.

Also in paragraph 5 of TR 2003/13 the Commissioner notes that the Courts have considered the meaning of the words in consequence of in several cases.

Of note are the decisions made by the Full Bench of 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, in the same case, 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. In doing so the Full Federal Court emphasised that a payment may be in consequence of the termination of employment even though the termination is not the dominant cause of the payment.

In particular, 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 to say, the view of both Courts was 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.

The phrase in consequence of and the decisions in Reseck and McIntosh were considered more recently by the Federal Court in Le Grand v. Federal Commissioner of Taxation³ (Le Grand), where 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.

Justice Goldberg concluded that the test for determining when a payment is made in consequence of the termination of employment is that which was expressed 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 noted in both paragraphs 6 and 28 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'.

Therefore 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.

In the present case, two related individual are directors and employees of a private Company (the employer).

Due to the completion of the contract and the loss of their client base, the outlook for any future contract is not promising. The Directors have decided that the Company will be wound up within the next 12 months.

The termination payment to be made to employees is in consequence of the termination of their employment. If not, for the winding up of the Company the employees will still be in employment with the employer. There is a clear causal connection between the termination of the employee's employment and the payment of the termination payment. The payment followed as an effect or result of the termination of the employee's employment. In other words, but for the termination of employment this payment would not have been made to the employees.

In view of the above, the 'termination payment' to be received by the employees is in consequence of the termination of their employment, and is therefore an employment termination payment under section 82-130 of the ITAA 1997.

The payment is made no later than 12 months after the termination of employment

The second requirement under section 82-130 of ITAA 1997 is that the payment be made within12 months of the termination of employment. Payments made outside 12 months will be taxed as ordinary income at marginal tax rates.

In the current case, the applicant advised that the payment will be made prior to the winding up of the Company. Consequently, the termination payment by the employer will be made within 12 months of termination of employment.

Accordingly, the requirement under paragraph 82-130(1)(b) of ITAA 1997 will be satisfied.

The payment is not a payment specifically excluded under section 82-135

The third condition for the payment to meet the criteria, as an employment termination payment is stated under paragraph 82-130(1)(c) of the ITAA 1997, is that the payment must not be specifically excluded under section 82-135.

Section 82-135 of the ITAA 1997 provides that certain payments are not employment termination payments, including:

· superannuation benefits;

· payment for unused annual leave or unused long service leave (and any other similar leave);

· the tax-free part of a genuine redundancy payment or an early retirement scheme payment; and

· reasonable capital payments for personal injury.

On the basis of the information provided by the applicant, it is considered that the payments are not payments that are specifically excluded under section 82-135 of the ITAA 1997. Therefore the condition under paragraph 82-130(1)(c) has been met.

As the payments to be made to employees satisfy all the conditions under subsection 82-130(1) of the ITAA 1997, the payments are employment termination payments for the purposes of section 82-130.

It should be noted that an employment termination payment cannot be rolled over into a complying superannuation fund.

Genuine redundancy payment

Under subsection 83-175(1) of the ITAA 1997 a genuine redundancy payment is one 'received by an employee who is dismissed from employment because the employee's position is genuinely redundant'.

In Taxation Ruling TR 2009/2 Income tax: genuine redundancy payments (TR 2009/2), the Commissioner has outlined the requirements to be satisfied before any payment made to a person whose employment is terminated qualifies for treatment as a genuine redundancy payment under section 83-175 of the ITAA 1997.

There are four necessary components within this termination requirement:

1. The payment being tested must be received in consequence of an employee's termination.

2. That termination must involve the employee being dismissed from employment.

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

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

Component 1: Payment being tested must be received in consequence of an employee's termination.

It has been established previously that the termination payment to be received in consequence of the termination of the employee's employment. Therefore the requirement of the first component of subsection 83-175(1) of the ITAA 1997 has been satisfied.

Component 2: That termination must involve the employee being dismissed from employment.

Under section 80-5 of the ITAA 1997, the concept of employment for the purposes of payments received on termination of employment is extended to include the holding of an office.

Section 80-5 of the ITAA 1997 states the following:

80-5 Holding of an Office:

If a person holds (or has held) an office, this Part applies to the person in the same way as it would apply if the person were (or had been) employed.

Some employees, in addition to being engaged as an employee of an employing entity, are also a directing mind of, or hold an office with, that entity. Such a person is known as a dual capacity employee.

In many cases a dual capacity employee will have made or actively participated in a decision to terminate their own employment, in either or both capacities.

However, in paragraphs 87 and 88 of TR 2009/2, the Commissioner states that:

87. ...a dual capacity employee, who, in their capacity as a directing mind of the employer, actively agrees to a decision of the employer to terminate their own employment, may nevertheless be dismissed if he or she does not freely consent to that termination decision. This will be evident where the influence of external circumstances is such that there is no apparent choice to be made or there is no awareness from those circumstances that consent or refusal is called for.

88. Such external circumstances include a termination decision that is dictated by legal or economic compulsion originating from outside the business. An industry specific or a general economic downturn is also more likely to give rise to these types of circumstances.

The Commissioner goes on to give an example where a directing mind of a company is not freely consenting to being dismissed in paragraph 90:

90. An example of a dismissal of this type is where a company loses the contract that is the only source of its business...

In this case, two individuals are both the directors and sole employees of the Company. The profitability of the business has been severely affected due to the loss of its client base.

As a result, the director's have made the decision to wind up the Company. In this instance, the directors have no choice to terminate their employment with the Company by abolishing their positions as employees.

They were therefore dismissed from their employment.

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

Component 3: That dismissal must be caused by the redundancy of the employee's position.

Based on the information provided, it is evident that the employee's position will no longer exit as soon as the winding up of the Company.

The third requirement of a genuine redundancy has therefore been satisfied.

Component 4: The redundancy payment must be made genuinely because of a redundancy.

The need for an employee's 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 this case, there is nothing to indicate that the redundancy is not genuine. Therefore, the fourth component of a genuine redundancy has been satisfied.

Further conditions for a genuine redundancy payment

Before a payment that meets the basic redundancy requirement in subsection 83-175(1) of the ITAA 1997 qualifies as a genuine redundancy payment, all other conditions in subsections 83-175(2) and (3) must be met. These conditions include:

· The payment must be made before a person turns 65 or an earlier mandatory age;

· The termination was not at the end of a fixed period of employment;

· the actual amount that was paid is not greater than the amount that could reasonably be expected to be paid had the parties been dealing at arm's length;

· the amount that was paid was in excess of what a person would have been entitled to receive if they had voluntarily resigned;

· there was no arrangement for re-employment with the employer or a related party after the termination date; and

· the payment was not in lieu of superannuation benefits.

On the basis of the information provided, it is considered that all the conditions of subsections 83-175(2) and 83-175(3) of the ITAA 1997 are also satisfied.

Consequently, it can be concluded that the 'termination payment' is a genuine redundancy payment as defined in section 83-175 of the ITAA 1997.

Section 83-170 then applies to treat so much of the relevant payment (that does not exceed the amount worked out under a specified formula) as tax-free. That is, the tax-free part 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.

Taxation of a genuine redundancy payment

Subsection 83-170(2) of the ITAA 1997 provides that so much of the 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.

The formula for working out the tax-free amount is:

Base amount + (Service amount × Years of service)

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

For the 2012-13 income year:

Base amount means $8,806; and

Service amount means $4,404.

The amount (if any) in excess of the tax-free amount is taxed as an employment termination payment.

Conclusion:

The 'termination payment' to be made to employees is a genuine redundancy payment.

Personal services income

As the Company has worked through the personal services business tests and they do not pass any of them, and the Company does not hold a personal services business determination from us, the personal services income (PSI) rules apply to the Company's business income.

When the PSI rules apply there are two main effects:

· the PSI the Company received will need to be attributed (treated as belonging) to each individual who performed the services, and the individual will need to declare the income in their individual tax return

· the Company will not be able to claim certain deductions against the PSI.

The Company has correctly assessed that they are required to attribute all PSI to Director B.

The deductions the Company can claim to reduce the amount of PSI attributed to Director B is limited to those Director B could have claimed in the same situation (the general rule). There are specific deductions that cannot be claimed by individuals earning PSI. Individuals earning PSI cannot deduct payments to an associate (spouse) for performing non-principal work. Principal work is the work required to be done under the contract and generates the PSI.

Payments to associates include remuneration such as salary or commission. The redundancy payment paid to Director A would fall into this category and would not be a payment for principal work. Therefore, the payment is non-deductible.

To prevent double taxation, where a payment to an associate is non-deductible under the PSI rules, the amount received by the associate is not included in their assessable income. In this case, both redundancy payments have been assessed as GRP's and are not assessable and not exempt income.

The redundancy payment to Director B is also non-deductible by applying the general rule above. As Director B would not have been able to deduct the amount of the redundancy payment as an individual earning PSI, the Company likewise will not be able to deduct that amount.

Therefore, the Company cannot reduce the amount of PSI attributed to Director B by the amount of redundancy payment paid to both Directors.

¹ (1975) 49 ALJR 370; (1975) 6 ALR 642; (1975) 5 ATR 538; (1975) 75 ATC 4213; (1975) 133 CLR 45

² (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325

³ [2002] FCA 1258; (2002) 124 FCR 53; (2002) 195 ALR 194; (2002) 2002 ATC 4907; (2002) 51 ATR 39