Edited version of private advice

Authorisation Number: 1052186792285

Date of advice: 8 December 2023

Ruling

Subject: Withholding tax on lump sum settlement payment

Question 1

Does the Employer have a Pay As You Go (PAYG) withholding obligation under section 12-120 of Schedule 1 to the Taxation Administration Act 1953 (TAA) in respect of a lump sum settlement payment made to the Former Employee under a court order?

Answer

No.

Question 2

Where the Employer dissects the court-ordered lump sum settlement amount paid to the Former Employee into payment components of salary/wages, personal leave, annual leave and long service leave, and applies a proportionate approach to identify and allocate amounts between each component:

a.    Would the Employer have a PAYG withholding obligation under section 12-35 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid salary/wages?

b.    Would the Employer have a PAYG withholding obligation under paragraph 12-85(b) of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid personal leave?

c.     Would the Employer have a PAYG withholding obligation under section 12-90 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid annual leave?

d.    Would the Employer have a PAYG withholding obligation under section 12-90 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid long service leave?

Answer

a.    Yes.

b.    Yes.

c.    Yes.

d.    Yes.

This private ruling applies for the following period:

Financial year ending 30 June 2024

The scheme commenced on:

24 July 2023

Relevant facts and circumstances

The Employer is in the hospitality business.

The Former Employee worked for the Employer for a period of XX years.

The Employer and the Former Employee were in dispute over the hours worked and the correct rate of pay.

Proceedings commenced in the Court for underpayment of wages, non-payment of accrued annual leave, and penalties under the Fair Work Act 2009 (Cth) and non-payment of long-service leave under the Long Service Leave Act 1958 (WA).

The total underpayments as calculated by the Employee are as follows:

•         salary wages ranging between $XXX,XXX and $XXX,XXX (depending on which industry award is deemed correct).

•         personal leave is $X,XXX

•         long service leave is $XX,XXX

The Employer and Former Employee have jointly consented to judgment in an all-inclusive, undifferentiated amount of $XXX,XXX.

The Employer has provided a copy of the court orders dated XX XXXX 2023 stating that the judgement for the claimant, in the amount of $XXX,XXX, is in satisfaction of all claims in the proceedings.

Relevant legislative provisions

Taxation Administration Act 1953 Schedule 1 Section 12-35

Taxation Administration Act 1953 Schedule 1 Paragraph 12-85(b)

Taxation Administration Act 1953 Schedule 1 Section 12-90

Taxation Administration Act 1953 Schedule 1 Section 12-120

Income Tax Assessment Act 1997 Section 82-130

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Section 83-295

Income Tax Assessment Act 1997 Section 118-37

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Question 1

Does the Employer have a Pay As You Go (PAYG) withholding obligation under section 12-120 of Schedule 1 to the Taxation Administration Act 1953 (TAA) in respect of a lump sum settlement payment made to the Former Employee under a court order?

Summary

No. The Employer does not have an obligation under section 12-120 of Schedule 1 to the TAA to withhold from the lump sum settlement amount, as payment of that amount is not due to the Former Employee having an incapacity to work.

Detailed reasoning

Part 2-5 of Schedule 1 to the TAA relates to the PAYG withholding system.

Payments and other transactions subject to PAYG withholding are called withholding payments. A summary of withholding payments is provided in subsection 10-5(1) of Schedule 1 to the TAA.

The list includes a compensation, sickness, or accident payment.

Division 12 of Schedule 1 to the TAA relates to payments from which amounts must be withheld.

Section 12-120 of Schedule 1 to the TAA provides that an entity that makes a payment of compensation or sickness or accident pay to an individual must withhold an amount if the payment:

•         is made because of that or another individual's incapacity for work; and

•         is calculated at a periodical rate; and

•         is not a payment made under an insurance policy to the policy owner.

Section 12-120 of Schedule 1 to the TAA is not satisfied as the payment is not due to the Former Employee having an incapacity to work. As such, the Employer does not have a PAYG withholding obligation under section 12-120 in respect of the lump sum settlement amount.

However, as provided in the response to Question 2 below, the Employer does have an obligation to withhold from the court-ordered settlement amount pursuant to sections 12-35, 12-85 and 12-90 of Schedule 1 to the TAA if that amount is dissected into payment components if an income nature, being salary/wages, personal leave, annual leave and long service leave, and a proportionate approach is used to identify and allocate amounts between these components.

Question 2

Where the Employer dissects the court-ordered lump sum settlement amount paid to the Former Employee into payment components of salary/wages, personal leave, annual leave, and long service leave, and applies a proportionate approach to identify and allocate amounts between each component:

a.    Would the Employer have a PAYG withholding obligation under section 12-35 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid salary/wages?

b.    Would the Employer have a PAYG withholding obligation under paragraph 12-85(b) of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid personal leave?

c.     Would the Employer have a PAYG withholding obligation under section 12-90 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid annual leave?

d.    Would the Employer have a PAYG withholding obligation under section 12-90 of Schedule 1 to the TAA in respect of the payment component pertaining to underpaid long service leave?

Summary

The single, undissected lump sum settlement payment replaces the Former Employee's assessable income. The Employer is required to dissect the lump sum payment using a proportionate approach to identify and allocate amounts between salary/wages, personal leave, annual leave, long service leave etc. These components of the lump sum payment are able to be estimated or valued on a reasonable basis. The relevant withholding schedule can then be applied to each payment component.

Detailed reasoning

Compensation payment for loss of income is income in nature

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; (1952) 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. Federal Commissioner of Taxation 79 ATC 4641; (1979) 10 ATR 411).

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? (TD 93/58) outlines the circumstances under which the receipt of a lump sum compensation or settlement payment is assessable as ordinary income. TD 93/58 states that where the compensation payment is for loss of income, the amount is assessable as ordinary income. Where a portion of a lump sum payment is identifiable and quantifiable as income, that portion of the payment will be assessable.

Ordinary income has generally been held to include income from three sources:

•         income from rendering personal services;

•         income from property; or

•         income from carrying on a business.

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 6-5 of the ITAA 1997, deals with receipts of ordinary income. Ordinary income is not clearly defined in the legislation and therefore the courts have identified a number of factors that indicate whether an amount has the character of income according to ordinary concepts.

It has been determined that a frequent characteristic of income receipts is an element of periodicity, recurrence or regularity (Federal Commissioner of Taxation v. Dixon (1952) CLR 540; (1952) 10 ATD 82). Other characteristics of income that have evolved from case law also include receipts that:

•         The receipt is earned

•         The receipt is expected

•         The receipt is relied upon

•         The receipt has an element of periodicity, recurrence or regularity; or

•         The receipt is for the replacement of income.

Taxation Ruling IT 2424 Income Tax: compensation payments in respect of unlawful acts of discrimination at paragraph 8 states that a compensation payment to make up for lost earnings or in substitution for income which would otherwise have been earned is in the nature of income and is liable to income tax.

However, if other factors are taken into account in determining the appropriateness and amount of the lump sum payment, this may lead to a conclusion that the lump sum amount has taken on the character of a capital payment. This maybe the case, where part of the lump sum settlement contains an amount for damages, penalties and interest.

Undissected lump sum compensation amounts

Paragraph 188 of Taxation Ruling TR 95/35 Income tax: capital gains: treatment of capital receipts (TR 95/35) states the following:

Whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt and the reasons why it was paid to the taxpayer (FC of T v. Slaven 84 ATC 4077; (1984) 15 ATR 242). In that case, the Federal Court was required to consider the nature of an amount of compensation received by the taxpayer following a motor vehicle accident. The Court (Bowen CJ, Lockhart and Sheppard JJ), in concluding that the amount was paid as compensation for loss or impairment of the taxpayer's earning capacity, stated (84 ATC at 4085; 15 ATR at 252):

'It is the character of the receipt in the hands of the taxpayer as recipient that must be determined'.

Paragraph 189 of TR 95/35 goes on to say:

The Courts have also emphasised that there is a clear distinction between the character of a payment and how it is calculated or quantified (for example, Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411) and that the method used: 'may provide a quite misleading guide to the character of the payment' (Deane and Fisher JJ, in the Tinkler case, 79 ATC at 4648; 10 ATR at 418).

It is the Commissioner's view, as outlined in paragraph 190 of TR 95/35, that the mere fact that compensation has been awarded as a lump sum and has not been dissected into its component elements is not sufficient to treat the whole receipt as one of capital. The facts and circumstances surrounding the receipt may enable an apportionment of the lump sum payment on a reasonable basis into its constituent elements.

In particular, the Commissioner states at paragraph 196 of TR 95/35 that a proportionate approach can be adopted to identify and allocate amounts of compensation to the various heads of claim if a taxpayer receives a single undissected lump sum in satisfaction of those claims.

Therefore, employers in these circumstances will need to take a closer look at the undissected lump sum settlement amount to determine the payment components for withholding and reporting purposes. The court order for the final settlement amount would have been calculated on some basis, and as such, it is reasonable for the employer to itself identify and allocate component amounts from the court order when an individual receives a single undissected lump sum amount.

Paragraph 208 of TR 95/35 states that it is likely that some information is available when a compensation claim is made which can be used to dissect a lump sum amount of compensation. Alternatively, the components of the lump sum ordinarily can be estimated or valued on a reasonable basis.

Each payment category that is income in nature should be subject to the relevant withholding rates unless it is considered capital in nature. There is a difference in withholding treatment for unpaid salary back payments, employment termination payments and unused leave payments on termination of employment.

PAYG withholding

As per the response to Question 1, a summary of withholding payments is provided in subsection 10-5(1) of Schedule 1 to the TAA. The list includes:

•         a payment of salary etc to an employee

•         a payment for termination of employment, and

•         a payment for unused leave on termination of employment.

Division 12 of Schedule 1 to the TAA relates to payments from which amounts must be withheld.

Section 12-35 of Schedule 1 to the TAA provides that an entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee (whether of that or another entity).

Section 12-90 of Schedule 1 to the TAA states that an entity must withhold an amount from a payment made to an individual where that payment is an unused annual leave payment or an unused long service leave payment (to the extent that the payment is included in the individual's assessable income).

The Australian Taxation Office (ATO) produces a range of tax tables or withholding schedules to assist payers in working out how much to withhold from payments they make to their employees or other payees:

•         Schedule 5 - Tax table for back payments, commissions, bonuses and similar payments is used if a payer makes a payment of salary or wages which is a back payment (including lump sum payments in arrears). A back payment is a payment that was meant to have been made in a prior period.

•         Schedule 7 - Tax table for unused leave payments on termination of employment is used if a payer pays an amount to an employee for unused leave on the termination of their employment. Unused leave payments on termination of employment includes, amongst others, annual leave and long service leave. It does not, however, include personal (sick) leave.

Capital payments

Section 118-37 of the ITAA 1997 states that you may disregard any capital gain or capital loss from any capital gains tax event 'relating directly ... to compensation or damages you receive for any wrong or injury you suffer in your occupation.'

Application to your circumstances

The Employer consented to judgment in an all-inclusive, undifferentiated amount of $XXX. The fact that the Court has awarded this amount as a lump sum and has not been dissected into its component elements is insufficient to treat the whole receipt as one of capital instead of ordinary income.

As outlined in the facts the single, undissected lump sum payment of $XXX represents:

•         unpaid salary and wages

•         unpaid personal leave

•         unpaid annual leave

•         unpaid long service leave

•         damages arising from its failure to keep and provide pay slips and employee records prescribed by the regulations

•         imposition of penalties, and

•         pre-judgement interest.

It is considered that the court-ordered lump sum payment was compensation intended to replace or substitute income that the Former Employee would otherwise have earned, thus having the characteristics of income according to ordinary concepts. Therefore, the payment is assessable income.

In line with the principles in TR 95/35 as outlined above, the Employer is required to:

•         closely examine the undissected lump sum settlement amount to determine the payment components for withholding and reporting purposes, and

•         apply a proportionate approach to identify and allocate amounts of compensation to these determined payment components. Discussions and pleadings from the Former Employee as part of the proceedings should enable an apportionment of the lump sum payment on a reasonable basis.

Each payment category that is income in nature should be subject to the relevant withholding rates unless it is considered capital in nature.

It is not for the Commissioner to determine the amount for each payment component which should be subject to withholding. The Employer needs to make a reasonable estimate of the amounts to be allocated to each of the undissected lump sum settlement amount's payment components and withhold from each payment component's allocated amount using the appropriate tax tables.

Potential payment components of the undissected lump sum settlement amount are listed below. The relevant tax tables to use in determining the amount of tax to withhold from any amounts allocated to these payment components are also provided.

•         unpaid salary and wages: Schedule 5 Tax table for back payments, commissions, bonuses and other payments

•         unpaid annual leave/unpaid long service leave: Schedule 7 Tax Table for unused leave payments on termination of employment

Other amounts

The undissected amount included an amount for damages, penalties and interest. These are not components that are required to have PAYG withheld from, the Former Employee will have to determine the tax treatment of these themselves.