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Self Managed Super Fund (SMSF) Article
Employment Termination Benefits

By Tony Negline.

This article may be out of date.

1st August 2007

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When an employment relationship is broken, the employer will sit down and work out an employee’s eligibility to a range of payments which the tax laws treat in a number of different ways.  The recent super reforms amend this tax treatment for some of these payments.  No one could possibly argue that this system is significantly simpler than the old system.

The termination payments effected include amounts for unused rostered days off, amounts in lieu of notice, golden handshakes, permanent invalidity payments (but not compensation for personal injury) and some death benefits.  It doesn’t include super fund benefits, unused annual or long service leave, or the tax-free part of a bona fide redundancy or approved early retirement payments.

Unused annual and long service leave are very common payments upon termination and the tax that applies often confuses people.  Unused annual leave will be taxed at 31.5% when paid as a result of bona fide redundancy, approved early retirement or invalidity and relates to employment before 18 August 1993.  All other unused annual leave payments are taxed at marginal tax rates.

Five percent of unused long service leave that relates to employment before 16 August 1978 will be taxed at marginal rates.  All of the unused long service leave attributable to the period between 16 August 1978 and 17 August 1993 will be taxed at 31.5%.  If the leave is paid as a lump sum because of bona fide redundancy, approved early retirement payment or invalidity then the leave that relates to post 17 August 1993 employment will be taxed at 31.5%.  All other long service leave will be taxed at marginal rates.

The tax-free part of a bona fide redundancy or approved early retirement payment is limited to $7,020 plus $3,511 for each completed year of service.  This amount cannot be rolled over to super and it must be taken as cash.  These thresholds are indexed each 1 July by movements in Average Weekly Earnings.

Now how are other amounts that are Employment Termination Payments taxed (which used to be called Employer Termination Payments)?

These payments will be split into two components called Tax-free and Taxable.  The Tax-free Component will be based on an employee’s service before July 1983 and Taxable Component will be the balance.  These components will be worked out from the day the employee joins the employer until the day the employment ceases.  (This is different to new rules which apply to super benefits but we will talk about this in another article.)

To qualify for concessional treatment these payments must be made within 12 months of the termination of employment.

The first point to note is that a transitional rule applies for ETPs paid after June 2007 and before July 2012 as long as the employee had a written agreement dated before 10 May which provided an entitlement to the payment.  Included in this category are benefits determined by an objective formula and benefits in kind such as shares.  Importantly an unlimited amount of these payments can be rolled over into a super fund.  These rolled over payments are called Directed Termination Payments.  Employees aged between 65 and 75 might need to satisfy a work test if they want to rollover the benefit.

If an employee under 55 does not rollover a transitional ETP but takes it as a lump sum then tax will apply.  Unsurprisingly the Tax-free Component will be tax-free.  The first $1 million of the Taxable Component will be taxed at 31.5%.  Amounts above $1 million will be taxed at the highest marginal rate (currently 46.5%).

Employees aged at least 55 have a different tax regime.  The Tax-free Component will again be tax-free.  The first $140,000 of the Taxable Component will be taxed at 16.5%.  The amount between $140,000 and $1 million will be taxed at 31.5%.  Amounts above $1 million will be taxed at the highest marginal tax rate.

Transitional termination payments that are rolled over into super funds will be taxed if they exceed the $1 million threshold.  Rolled over amounts above this threshold will be added to the personal deductible contributions and all employer contributions made in a year.  Deductible contributions above your deductible contribution cap are taxed at 46.5%.

Finally there is official paper-work and processes for both the employer and employee that must be completed to correctly action Employment Termination Payments.

What happens if there is no formal agreement?  Another system will apply.  Rolling the payment over to super will not be available.

For those who are at least 55 in the year the payment is made – note, not when the payment is actually made – the Taxable Component will be taxed at 16.5% up to the first $140,000 which is called the Employment Terminations Payment Cap.  Above this limit the highest marginal tax rate will apply.

For those under 55 the tax-rates will be 31.5% and 46.5% respectively.

Employer provided lump sums paid on an employee’s death are a whole new game.  If paid to a dependant – spouse, minor children or financial dependant adult children and potentially others) – then amounts below the Employment Terminations Payment Cap are tax-free.  If paid to non-dependants, the tax-rate is 31.5%.  In both cases payments above the Cap are taxed at 46.5%.

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