Employment termination settlement and concessional tax treatment

We recently came across an employment termination scenario where the matter was settled by a deed of release resolving/withdrawing a Fair Work claim. The deed stated (as is common) that the termination of employment occurred ‘…by way of the Employee’s resignation by operation of this deed’.

While this language may be preferred by the employer the wording of the deed of release could have significant tax implications for the employee.

Termination of employment by way of an employee’s resignation (including under a deed) would ordinarily be treated as a voluntary resignation. This classification can have very different tax consequences compared to a termination payment received as a result of a settlement for a genuine dispute (such as personal injury, unfair dismissal, harassment, or discrimination) or a genuine redundancy.

Even if the employee is satisfied with the gross settlement amount, this might not be the case when the tax implications are taken into account (such as tax to be withheld or the net outcome after the final tax liability is ascertained) which may significantly differ from what was ‘expected’ (and the gross settlement amount).

The types of concessional tax treatment for payments received as a result of termination of employment (ignoring termination payments related to death benefits) are broadly described as:

Tax-free treatment:

Where the termination relates to Genuine Redundancy Payments and Early Retirement Scheme Payments (Div 83-C), it is not subject to tax in the hands of the recipient (not assessable and not exempt income) up to a tax-free cap (for FY2024, that cap is $11,985 plus  $5,994 for each year of completed service). The excess will be an employment termination payment (ETP) as defined in s.82-130 and taxed (due to a tax offset) at a maximum rate of 15% or 30% (plus Medicare and depending on whether or not the employee is under or over preservation age) up to the applicable ETP cap amount (as indexed) or the whole of income cap, with the remainder taxed at marginal rates (with top marginal rate applying for withholding purposes).

ETP Cap amount

For FY2024 the ETP Cap amount is  $235,000 (and is indexed annually).

The ETP cap amount applies to ETPs that are “excluded payments” and include genuine redundancy or early retirement scheme payments that  exceed the tax-free cap or payments received as compensation for personal injury, unfair dismissal, harassment or discrimination (described as an excluded payment under s.82-10(6)). This includes termination payments where the payment is partly (not wholly) an excluded payment.

Whole of Income Cap 

The whole of income cap amount is $180,000 and is not indexed.

The whole of income cap applies in conjunction with the indexed ETP cap amount to ETPs that are not excluded payments. The applicable cap which is used to determine entitlement to the 15% or 30% tax rate is the lesser of:

• the ETP cap amount (as indexed) or
• the amount worked out under the whole of income cap.

The applicable whole of income cap amount is worked out by subtracting the taxpayer’s taxable income for the income year in which the ETP is paid  from the $180,000. Taxable income for this purpose excludes the ETP in question.

Where an employee’s resignation is voluntary, the termination payment(s) received by the employee is an ETP and would generally be subject to the whole of income cap (reduced by their taxable income amount disregarding the termination payment received). For example if the employee’s taxable income for FY2023 was $120,000 and he had resigned in the same year and received an ETP of $80,000. The $180,000 whole of income cap is reduced to $60,000. Applying the lesser of the whole of income rule as outlined above, up to $60,000 of the ETP received is subject to the ETP concessional tax rate of 15% or 30% (depending on whether or not the employee is under or over preservation age). The remainder $20,000 ETP is taxed at marginal rates (with top marginal rate applying for withholding purposes).

However, the circumstances that led to the employee’s resignation by way of a deed of release may support the termination payment being identified as an excluded payment which in turn will be subject to the ETP cap amount (i.e., $235k for FY2024) if the underlying dispute and the settlement satisfy the following conditions:

1. the payments were made in connection with a genuine dispute;
2. are primarily compensation for personal injury, unfair dismissal, harassment, or discrimination claims; and
3. exceed the amount that could reasonably be expected if the employee voluntarily resigned.

Concessional treatment under the ETP cap amount may also be available under s.82-10(6) if the payment would have included a tax-free amount (e.g. redundancy amount) but for the age of the recipient. In such cases, while the payment may not be eligible for tax-free treatment, the concessional treatment under the ETP cap amount can be used when determining the tax liability (and not the usual lesser of whole of income cap rule being applicable).

The key take-away is that describing the termination of employment as a voluntary resignation in a deed of release (no matter how expedient that may be) in circumstances that indicate otherwise could have significant adverse tax consequences.

Our previous articles on ETPs include:

Redundancy payments and withholding – intricacies and complexities

Will FBT apply if an employer car is gifted to a retiring employee?

And what would Artificial Intelligence (AI) have to say about this type of payment?

Given the recent interest in the role AI can play in the professional advisory space, we asked the same question on ChatGPT3.5 – see response here. The response was not specific to the scenario and did not relate to Australian income tax law. It also generated additional (false) information outside the scope of the question in order to produce text that sounds coherent within the context of the prompt (commonly known as AI hallucination). In particular, when provided with the relevant legislation for interpretation (i.e., s.82-10(6) of ITAA 1997), it incorrectly concluded that these payments are tax-free. Our ‘experiment’ highlights limitations using AI as a research tool.

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