Tax treatment of employee compensation on termination of employment

There are various ways that employment may be terminated, and the resulting compensation to which the employee is entitled may differ depending on the terms of the employment contract, the manner and reason for termination and 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 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 is income or capital in nature.

According to the replacement principle, compensation received in substitution for another amount will take on the character of the amount which it is replacing (FCT v Dixon (1952) 86 CLR 540). That is, a compensation payment, even if paid as a lump sum, is income in nature if it is received as a replacement for an item that would have had the character of income.

In an employment context, the characterisation of a compensation payment made to an employee on termination requires the identification of the underlying amount for which 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 otherwise be ordinary income and therefore 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 otherwise be an income stream throughout the notice period. Consequently, the amount is ordinarily 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 regardless of whether the compensation is calculated by reference to unpaid salary or lost income (Tax Determination TD 93/29).
• Compensation for restriction of other rights: An amount received as consideration for an individual entering 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 company and was paid a lump sum amount in consideration for him not divulging certain confidential information. The Federal Court found that the payment was not assessable to the taxpayer as ordinary income as it was not incidental to 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 a lump sum does not preclude the amount from being considered ordinary income. If the recovered amount includes an amount that would otherwise have been income in a subsequent income year (pursuant to the replacement principle), the entire lump sum will be assessable income in the income year in which it is received (Re Hannavy and FCT (2001) 47 ATR 1018).

Where a lump sum compensation payment comprises both income and capital amounts, the amount will only be apportioned if the different components are definitively identifiable (Tax Determination TD 93/58). If the amount cannot be apportioned, the entire amount will 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 determined, its tax treatment can be 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 might be assessable to the employee as an “Employment Termination Payment” (ETP) under Division 82 of the Income Tax Assessment Act 1997.

ETPs are concessionally taxed, meaning a portion of the ETP may be tax free and the recipient may also receive a tax offset so 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 is a payment received by an individual 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 cannot 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 a 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 invalidity of the employee.

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

Genuine redundancy payments

In the event that the employee is terminated due to their position being made redundant, any termination payment received by the employee may be a genuine redundancy payment rather than an ETP.

A genuine redundancy payment is the portion of the payment made to an employee which results from the employee’s position being made genuinely redundant. The decision to dismiss the employee must be solely that of the employer as opposed to an employee’s decision to resign or retire. In order to be a genuine redundancy payment, the following 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.

A payment will not be a genuine redundancy payment where it is 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 worked out using a statutory formula and depends on the number of years that the employee worked for the employer. Any payment in excess of the tax free component will 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 on the purpose for which they were incurred (Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634). Broadly, an employee’s legal expenses will be deductible if they are incurred in gaining or producing the employee’s assessable income or in carrying on a business, and are not capital or private in nature.

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

If the legal expenses are not deductible, but are capital in nature, the CGT rules need to be considered. In such a case, the legal expenses may form part of the cost base of a relevant asset and, depending on the nature of the capital asset, the 50% CGT discount may be available.

Common examples

The following are common examples of the taxation treatment for legal expenses that may be incurred by an employee in 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 be 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).