Edited version of private advice

Authorisation Number: 1051999989220

Date of advice: 30 June 2022

Ruling

Subject: Employment termination payment - settlement

Question

Is the Payment made to the Taxpayer in respect of a claim as part of the Agreement assessable as an employment termination payment as defined in section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Relevant facts and circumstances

You entered into a Deed of Settlement and Release Agreement (Agreement). The Agreement is between you and your Employer

The Agreement provides:

Recitals

A. The Taxpayer is employed by the Employer

B. The Taxpayer lodged a claim for workers compensation under the Safety, Rehabilitation and Compensation Act 1988 (Cth) (SRC Act) for compensation alleging that he suffered an injury at work. Liability has been accepted as compensable injury.

C. After a year, the Taxpayer lodged additional claim for workers compensation for additional injury as part of the original compensable injury. Liability has been denied for the additional claim under the SRC Act. The Taxpayer has disputed the rejection of their claim at the Administrative Appeals Tribunal (the AAT) and filed an Application for Review action.

D. The Employer denies that it has any liability to the Taxpayer.

E. The parties agreed to settle the said claim and the differences between them on the terms of this agreement.

F. The Taxpayer agreed to resign from their employment.

G. The Agreement states that the Employer shall make the Payment to the Employee in respect of any claim by the Employee for non-statutory, non-economic loss payment.

1.    Payments

The Employer will make the Payment to Taxpayer in addition to accrued entitlements to long service leave and annual leave, less tax deducted at the appropriate rate. The partial Payment will be paid within seven days of the Employer receiving a duly executed copy of this Agreement from the Taxpayer. The remaining Payment will be paid within 28 days of the Employer receiving:

a) sealed orders of the AAT decision filed in respect to action;

b) Deed of Release signed by Taxpayer; and

c) Clearance of Notice of Charge from Medicare Australia and Centrelink.

The Employer will also pay to the Taxpayer a sum inclusive of GST, for legal costs and disbursements incurred by Taxpayer.

2.    Release from claims

The Taxpayer acknowledges that the Employer makes the Payment in full settlement of all claims against Employer arising from the Taxpayer's employment with the Employer and that the claim described in Recital B is settled with a denial of liability by the Employer and solely to avoid further litigation. This Agreement must not be interpreted as an admission by the Employer of liability to the Taxpayer for any matter.

The Taxpayer releases absolutely and discharges the Employer from all claims, actions, suits, causes of action, demands, liability, damages and costs arising in any way concerning or in the course of the Taxpayer's employment with the Employer or its cessation that the Taxpayer has now or may have had in the future if the parties had not executed this Agreement.

By executing the within Agreement and by reason of the Taxpayer resignation, the Taxpayer acknowledges that the Employer is relieved of any obligation to offer suitable employment pursuant to section 18(1) and sections 18(2) and 18(2) of the Return to Work Act 2014.

Under the terms of the Agreement, you resigned from employment.

The Tax Statement summary shows that the Payment wholly comprised a taxable component on which tax was withheld.

You incurred legal costs relating to the Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 82-10

Income Tax Assessment Act 1997 Section 82-130

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Section 82-145

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subparagraph 118-37(1)(a)(i)

We followed these ATO view documents

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'

Reasons for Decision

Non-economic loss

Section 6-5 and section 6-10 of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary and statutory income (for example, capital gains) derived directly and indirectly from all sources, whether in or out of Australia during the income year.

The ITAA 1997 does not provide specific guidance on the meaning of ordinary income. However, a substantial body of case law exists which identifies its likely characteristics. Amounts that are periodic, regular or recurrent and relied upon by the recipient for their regular expenditure are likely to be ordinary income, as are amounts that are the product of any employment of, or services rendered by, the recipient. Further, amounts which compensate for lost income or serve as a substitute for other income are themselves income according to ordinary concepts.

In your case, the Payment received is part of the Agreement in relation to your claim for compensation or damages for an injury at work, to avoid the costs of litigation in respect of the applications of the SRC Act claims but without the Employer's admission of guilt.

Non-economic loss is defined in the SRC Act as:

•         pain and suffering

•         loss of amenities of life

•         loss of expectation of life

•         disfigurement

•         any other loss or detriment of non-economic nature.

Therefore, the Payment made to you does not satisfy the definition under non-economic loss as defined in the SRC Act and is assessable income.

Employment termination payment

Division 82 of the ITAA 1997 sets out how ETPs are treated for income tax purposes.

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

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 that termination (but see subsection (4)); and

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

Section 82-135 of the ITAA 1997 states:

The following payments you receive are not employment termination payments:

(a) a superannuation benefit (see Divisions 301 to 307);

(b) a payment of a pension or an annuity (whether or not the payment is a superannuation benefit); and

(c) an unused annual leave payment (see Subdivision 83-A);

(d) an unused long service leave payment (see Subdivision 83-B);

(e) the part of a genuine redundancy payment or an early retirement scheme payment worked out under section 83-170 (see Subdivision 83-C);

(f) ...

(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 );

To determine if the Payment made constitutes an ETP, all the conditions in section 82-130 of the ITAA 1997 must be satisfied.

Failure to satisfy any of the conditions will result in the Payment not being considered an ETP.

In consequence of termination of employment

The first condition requires that the Payment is received by the employee in consequence of the termination of his or her employment.

In your case there was a 'termination of employment' as you resigned your employment with the Employer in accordance with the Agreement.

The next issue to determine in relation to the first condition is whether the Payment made to you was 'in consequence of' the termination of employment.

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the courts have interpreted the phrase in a number of cases. Whilst the courts have divergent views on the meaning of this phrase, the Commissioner's view on the meaning and application of the 'in consequence of' test are set out 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'.

While TR 2003/13 considered the meaning of the phrase 'in consequence of' in the context of the eligible termination payments, TR 2003/13 can still be relied upon as both the former provision under the Income Tax Assessment Act 1936 and the current provision under the ITAA 1997 both use the term 'in consequence of' in the same manner. It should be noted that the eligible termination payments ceased to exist from 1 July 2007 and were replaced by employment termination payments.

In paragraphs 5 and 6 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 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.

In paragraph 6 of TR 2003/13, the Commissioner recognises that:

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 received 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 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 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 their former employer, in relation to the termination of their 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.

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 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 ETP 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.

In your case, as mentioned previously, your employment was terminated when you resigned in accordance with the Agreement.

The Agreement was signed between you and the Employer. In the Agreement you agreed to the Employer paying you:

•         $XXX gross settlement sum in addition to your accrued entitlements; and

•         $XX for contribution for legal costs you incurred.

You and the Employer agreed to settle the claim and your differences under the terms of the Agreement. Your settlement payment is to extinguish all claims and all matters relating to your workplace injury and any future obligation of the Employer to offer suitable employment pursuant to section SRC Act. A key condition of the Payment was that you terminate your employment.

As per paragraphs 5 and 6 of TR 2003/13, it is clear that but for the termination of employment by resignation on the specified date, the amount received for the execution of the Agreement and relating to not pursuing your Employer under SRC Act, would not be paid to you.

While the Agreement is a direct cause of the Payment, the Payment will not be made unless there is a termination of your employment. That is, there will be a sequence of events leading to the termination which had a relationship and connection, which ultimately led to the Payment being made. The various causes of action to be settled by the Agreement are interwoven and intertwined with termination of employment.

Therefore, the first requirement under subparagraph 82-130(1)(a)(i) of the ITAA 1997 has been satisfied.

Payment received no later than 12 months after termination

In addition to meeting the other conditions for a payment to be an employment termination payment, paragraph 82-130(1)(b) of the ITAA 1997 specifies that the payment must be received within 12 months of the employee's termination of employment, unless they are covered by a determination exempting them from the '12- month rule'.

As shown in the facts, your employment was terminated after signing the Agreement and the Payment was immediately paid to you.

Accordingly, as the Payment was made within 12 months of the termination of your employment, the requirement in paragraph 82-130(1)(b) of the ITAA 1997 has been satisfied.

A payment mentioned in section 82-135 of the ITAA 1997

Paragraph 82-130(1)(c) of the ITAA 1997 specifies that an ETP does not include a payment mentioned in section 82-135 of the ITAA 1997. An exclusion under paragraph 82-135(i) of the ITAA 1997 includes a capital payment for personal injury as compensation for your inability to be employed.

In Re Luke and Federal Commissioner of Taxation [2011] AATA 801; (2011) 2011 ATC 10-216; the Administrative Appeals Tribunal (AAT) accepted that the taxpayer had been adversely affected by what they perceived to be unreasonable harassment and discrimination in their employment, but said that 'personal injury' does not extend 'beyond physical injury and mental illness to include emotional hurt'. The AAT added that:

Evidence is required that the payment had some form of identifiable and unambiguous connection with a personal injury, for which compensation was necessary as a reflection of the fact that the applicant's capacity to derive income from personal exertion had been impaired.

In view of the above, a physical and/or mental injury would require diagnosis by a qualified medical practitioner to fall within the meaning of 'personal injury'. The payment must also be calculated by reference to the nature of the injury and the extent to which the injury will affect your capacity to derive income from employment.

Although the settlement payment, received for the execution of the Agreement and for not pursuing your Employer under the SRC Act, relates to your claim for injury, the Employer has denied any liability to the allegations and you have released them from all claims relating to the matter. The Agreement does not provide any medical qualification or clarification that the payment was calculated with regard to your likely loss of income producing capacity.

Therefore, in accordance with paragraph 82-130(1)(c) of the ITAA 1997, the payment is not for, or in respect of, personal injury which would be is excluded from being an ETP under section 82-135.

Conclusion

The Payment made to you in addition to your accrued entitlements is an ETP.

An ETP may comprise of a:

•         Tax free component - as provided in section 82-140 of the ITAA 1997, this includes an invalidity segment within the meaning of section 82-150 (if any) and/or a pre-July 83 segment within the meaning of section 82-155 (if any); and

•         Taxable component - the amount remaining after deducting the tax-free component from the total payment, as prescribed in section 82-145 of the ITAA 1997.

As shown in the facts, the Payment does not contain an invalidity segment but is comprised wholly of a taxable component.

Subsection 82-10(2) of the ITAA 1997 provides that the taxable component of a life benefit termination payment, which the Payment in your case satisfies, is assessable income. Accordingly, it is to be included in your income tax return for the 2021-22 income year.

In relation to the rate of tax that applies to the Payment, subsection 82-10(3) of the ITAA 1997 specifies that a taxable component is subject to tax and the rate applied depends on the recipient's age.

As you were under your preservation age when you received the Payment the maximum rate of tax is 32%. Accordingly, the tax which the Employer withheld from the Payment is correct.

Legal expenses

You incurred legal expenses relating to the Agreement.

Apart from specific provisions, legal expenses are deductible under section 8-1 of the ITAA 1997 if incurred in gaining or producing assessable income, or if necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income.

In determining whether a deduction for legal expenses is allowed, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Legal expenses are generally deductible by employees and former employees if they arise out of:

•         recovering unpaid wages, unused annual leave and unused long service leave in accordance with the principles contained in Taxation Determination TD 93/29

•         instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement

•         preventing redundancy or dismissal

•         defending the manner in which employment duties are performed.

In contrast, legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal, are not deductible. It is irrelevant if any amount awarded to the employee is calculated by reference to unpaid salary or lost income. As outlined at paragraph 5 of TD 93/29, legal expense relating to an action for damages for wrongful dismissal are not deductible as the claim is of a capital nature.

ETP's are subject to special tax treatment that may result in some or all of the amounts being included in assessable income. However, the fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in assessable income.

As ETP's are capital in nature, any legal expenses associated with obtaining the ETP are also capital in nature and not deductible.

As your legal expenses related to an item which is capital in nature, the legal expenses are also capital in nature. Therefore, the legal expenses are not deductible under section 8-1 of the ITAA 1997.