Taxation of employment termination payments (ETPs)

Redundancies, whether forced or elective, can become complex as there are many taxation issues to consider when receiving a payout.

The most common form of payment an employee will receive is an employment termination payment. Employment termination payments (ETPs) include payments for unused rostered days off or for unused sick leave; payments in lieu of notice; payments due to redundancy or early retirement that exceeds the tax-free amount, or payments due to invalidity.

Mistakes in employment termination payments (ETPs) are common as it is up to the employer to work out how much is owed to the employee and how much tax needs to be withheld from the various components that make up an ETP. Errors are generally made around how much leave is owed, whether the payment includes the correct tax-free amount and if the correct tax rate is used.

ETPs are made up of two components, the tax-free component and the taxable component. The tax treatment of the components will vary depending on the type of redundancy, whether it is an early retirement scheme; genuine redundancy; invalidity or compensation for personal injury, unfair dismissal, harassment and discrimination.

The ATO classifies a redundancy as “genuine” if the employer has made a decision that the job no longer exists and employment is to be terminated. A genuine redundancy has special tax treatment where an amount paid up to a limit is tax-free. To qualify for tax concessions the employee must be dismissed before the day they turn 65 and there must be no arrangement at the time of termination to re-employ the dismissed person.

Employees being offered a redundancy payment should check the right tax is applied to the right component. A genuine redundancy payment is tax-free up to a limit based on a formula which includes the base amount determined by the ATO. This is added to a service amount multiplied by the years of service. The base rate for 2015-16 is $9780 and the rate for each completed year of service is $4891. The formula depends on completed years.

Tax will be withheld by the employer where there is unused long service leave, rostered days off, pay in notice of lieu or golden handshakes. The tax withheld on long service leave would be either 17 per cent or 32 per cent (including Medicare) depending on the age of when redundancy occurred. For those over the preservation age (usually 55 and over) you will pay 15 per cent tax when you take redundancy and for those younger, 30 per cent tax will be payable, excluding Medicare.

Amounts that exceed the tax-free limit will be taxed based on your preservation age at the date of the redundancy and individual marginal tax rate. There is an ETP cap, which for the 2015-16 year is $195,000. When the cap is reached, the individual’s marginal tax rate is applied, plus the Medicare levy.

Employees receiving a redundancy payout need to ensure they understand how the calculations have been done and seek professional advice to confirm they are accurate.