Tax treatment of employee compensation on termination of employment

There are various ways in which employees could also be terminated, and therefore the resulting working compensation audit to which the worker is entitled may differ counting on the terms of the utilization contract, the manner and reason for termination, and therefore the bargaining power of the parties.

The tax treatment of termination payments will depend on how the employee was dismissed and what type of right the compensation is replacing. In some cases, there will be the concessional treatment of the termination payments afforded to the exiting employee.

Will compensation on termination of employment be assessable as income to the employee?

The tax treatment of compensation payments made on the termination of employment depends on the character of the compensation. That is, whether it's income or capital in nature.
According to the replacement principle, compensation received in substitution for an additional amount will combat the character of the quantity which it's replacing (FCT v Dixon (1952) 86 CLR 540). That is, a compensation payment, albeit paid as payment, is income in nature if it's received as a replacement for an item that might have had the character of income.

In an employment context, the characterization of a compensation payment made to an employee on termination requires the identification of the underlying amount that the employer is required to compensate (eg annual leave, notice period).

Common examples

Some common compensation payments made to employees on the termination of their employment include:

• Unpaid wages, annual leave, and long service leave: These payments are in substitution for what would rather be ordinary income and thus are usually assessable as income (Tax Determination TD 93/29; ATO ID 2002/391 and ATO ID 2004/659).

• Payment in lieu of notice: This amount is in substitution for what would rather be an income stream throughout the notice period. Consequently, the quantity is ordinary income in nature (Romanin v FCT (2008) 73 ATR 760).

• Wrongful dismissal compensation (eg unfair dismissal): This amount is in substitution for the denial of a right to be lawfully dismissed. This right is capital in nature and accordingly, the compensation is capital and not assessable. This will be the case no matter whether the compensation is calculated by regard to unpaid salary or lost income (Tax Determination TD 93/29).

• Compensation for restriction of other rights: An amount received as consideration for a private getting into a restrictive covenant will ordinarily be capital in nature (Margerison v Tyresoles Ltd (1942) 25 TC 59). For example, in Paykel v FC of T 94 ATC 4176, the taxpayer retired as an employee of a corporation and was paid a payment amount in consideration for him not divulging certain confidential information. The court found that the payment wasn't assessable to the taxpayer as ordinary income because it wasn't accompanying the income-earning activities of the taxpayer and was a one-off payment with no suggestion that the payment would be repeated.

Receiving compensation payments as payment doesn't preclude the quantity from being considered ordinary income. If the recovered amount includes an amount that might otherwise are income during a subsequent income year (pursuant to the replacement principle), the whole payment is going to be assessable income within the income year during which it's received (Re Hannavy and FCT (2001) 47 ATR 1018).

Where a payment compensation payment comprises both income and capital amounts, the quantity will only be apportioned if the various components are definitively identifiable (Tax Determination TD 93/58). If the quantity can't be apportioned, the whole amount is going to be considered capital in nature (McLaurin v FCT (1961) 104 CLR 381; Allsop v FCT (1965) 113 CLR 341). Once the character of the compensation payment is decided, its tax treatment is often more easily assessed.

Tax treatment in the employee’s hands

To the extent that a payment to an employee on the termination of their employment constitutes income in their hands, the payment could be assessable to the worker as an “Employment Termination Payment” (ETP) under Division 82 of the Tax Assessment Act 1997.

ETPs are concessionally taxed, meaning some of the ETP could also be tax-free and therefore the recipient can also receive a tax offset in order that payments of an ETP, that are below the applicable ‘cap’ (see below), are only subject to a maximum rate of tax of 30%.

An ETP may be a payment received by a private as a result of the termination of their employment (or another person’s employment). It must be paid to the individual within 12 months of termination and can't be excluded from the definition of an ETP.

Some examples of payments that are not ETPs include:

• superannuation benefits;
• unused annual leave or long service leave;
• deemed dividends;
• the tax-free component of a genuine redundancy payment (see below); and
• certain capital payments for personal injury or restraint of trade contracts.

An ETP received by an individual during their life is a ‘life benefit termination payment’ and consists of both a tax-free and taxable component. The tax-free component comprises:

• any portion of the payment attributable to services provided pre-July 1983; and
• any portion of the payment that is compensation to the employee for termination of employment due to the invalidity of the employee.

The remainder of the life benefit termination payment is taxable and can be included within the individual’s assessable income. The individual may also be entitled to a tax offset for the portion of the ETP that falls below the relevant cap (either the ETP cap or ‘whole-of-income’ cap, depending on the type of payment). The tax offset will make sure that the taxable component of the ETP that's within the cap is taxed at only 15% or 30% (depending on the individual recipient’s age). Any a part of the ETP above the cap is taxed at the highest marginal rate. In the 2015/16 year, the ETP cap is $195,000 and therefore the whole-of-income cap is $180,000.

Genuine redundancy payments

In the event that the worker is terminated thanks to their position being made redundant, any termination payment received by the worker could also be a real redundancy payment instead of an ETP. A genuine redundancy payment is that the portion of the payment made to an employee which ends up from the employee’s position being made genuinely redundant. The decision to dismiss the worker must be solely that of the employer as against an employee’s decision to resign or retire. In order to be a real redundancy payment, the subsequent conditions must be met:

• the employee must be dismissed before turning 65 (or earlier if the employee’s employment was set to terminate at a particular predetermined point in time);
• the dismissal and the payment were at arm’s length; and
• there was no arrangement for the employer to hire the employee after the dismissal.

Payment won't be a real redundancy payment where it's an ETP or in lieu of superannuation benefits.

A genuine redundancy payment comprises a taxable component and a tax-free component. The tax-free amount is figured out by employing a statutory formula and depends on the number of years that the worker worked for the employer. Any payment in more than the tax-free component is going to be taxable to the individual as assessable income.

Can the employee obtain a deduction for legal expenses incurred in relation to the termination of employment?

The deductibility of the legal expenses will depend upon the aim that they were incurred. Broadly, an employee’s legal expenses are going to be deductible if they're incurred in gaining or producing the employee’s assessable income or in carrying on a business, and aren't capital or private in nature.

Similar to the discussion above, if the legal expenses are incurred to recover a payment that's income in nature, the legal expenses also will be income in nature and deductible. Where legal expenses are incurred for dual purposes (i.e. both income and capital amounts) the portion concerning the identifiable income component could also be deductible.

If the legal expenses aren't deductible but are capital in nature, the CGT rules got to be considered. In such a case, the legal expenses may form a part of the value base of a relevant asset and, counting on the character of the capital asset, the 50% CGT discount may be available.

Common examples

The following are common samples of the taxation treatment for legal expenses which will be incurred by an employee within the course of employment:

Preventing redundancy: Legal expenses incurred to prevent redundancy or dismissal are generally revenue in nature and deductible (AAT Case 5822 (1990) 21 ATR 3357; FCT v Day (2008) 70 ATR 14).
Release from employment: Legal expenses incurred in obtaining a release from an employment contract in order to take up a position elsewhere are ordinarily not deductible (Kemp v FCT (1992) 24 ATR 75).
Obtaining re-employment: Legal expenses incurred in obtaining employment or re-employment (including the preparation of an employment agreement) are not deductible as they are considered preliminary expenses of a capital nature (FCT v Maddalena (1971) 2 ATR 541; AAT Case Re Museth and FCT (2006) 62 ATR 1243; [2006] AATA 482; Ruling TR 2000/5).