Are the new termination payment rules “fair”?

SMSF technical expert and columnist for The Australian newspaper
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Often when you terminate employment, your employer may pay you a lump sum of money.

Between July 1983 and July 2012 you were permitted to roll most of these payments over to your super fund, but this was banned by the 2007 Better Super policy.

I’m not entirely sure why rolling over these benefits to super was stopped – I think it was done to restrict your ability to accumulate too much money in the super system.

Despite this, once you receive a termination payment, you can contribute it into your super fund as a non-concessional contribution as long as you are eligible to make such contributions and keep within the $150,000 cap. But first, you’ll have to see how much you’re left with.

As part of this year’s Federal Budget, the amount of tax payable on these benefits was changed with effect from 1 July 2012. This amendment, which has already been legislated, was done in the name of fairness. As soon as anyone mentions fairness and tax in the same sentence, I think, “Well, here comes ridiculous complexity”.

I regret to say that in relation to these changes, my maxim holds. Let me show you why.

How termination payments are taxed

Your termination benefit will be made up of any of the following:

  • Unused annual leave
  • Unused long service leave
  • Tax-free benefit
  • Taxable benefit

We won’t look at how unused annual or long service leave are treated except to note that they’re subject to special tax rules. Unused sick leave typically forms part of either the tax-free or taxable benefit.

Specific tax concessions apply if the benefit is paid due to an employee’s death (in 2012/13 they’re tax-free up to the first $175,000).

A tax-free benefit will arise if employment is terminated because of genuine redundancy or as part of an early retirement scheme approved by the Australian Taxation Office (ATO). At present, this amount is limited to $8,806 plus $4,404 for each completed year of service.

All other benefits are split between tax-free and taxable components. For most people, the tax-free portion will relate to any employment service performed before 1 July 1983 (there are special rules about how the tax-free amount is worked out if a person is permanently disabled).

Before 1 July 2012, the Taxable Component was taxed at 16.5% (if you were aged at least 55 when you received it) – officially this is called the ‘ETP tax offset’ – for the first $175,000 and then different tax rates applied on higher amounts. For those aged under 55 the tax rate was 31.5%. The $175,000 is called the ‘ETP-cap’ and this figure is indexed each 1 July. This is the 2012/13 amount.

The taxable component will now be subject to two tests:

  1. The ‘ETP-cap’ (which applies to genuine redundancy and early retirement scheme payments over the tax free limit, invalidity payments and compensation payments); and
  2. A ‘Whole-of-income-cap’ which is $180,000 (there is no inbuilt indexation to this amount in the legislation).  This test only applies to some types of payments such as payments that don’t meet genuine redundancy rules, golden handshakes, payments for rostered days off and unused sick leave, and gratuities.

Under these new rules, there are effectively now two ETP-caps.

For the ‘ETP cap’, the taxable component is assessed against the $175,000 cap.

The whole-of-income cap works in an entirely different way and is reduced by any other taxable income earned.  It says that you subtract your taxable income in a year from $180,000 You then receive concessional tax treatment on the amount up to the lesser of the ‘ETP Cap’ and the calculated ‘whole of income cap’.

Example

Let’s look at a reasonably simple example provided by the Government.

Hania is made redundant and is paid a $190,000 severance benefit in 2012/13 (of which $50,000 could reasonably be expected to be paid if she left her employment voluntarily).  Her taxable income from all other sources for 2012/13 is $200,000. Hania is over 65 and not entitled to the tax-free genuine redundancy benefits mentioned above.

The $140,000 of her redundancy benefit falls within her ETP-cap and is therefore eligible for the ETP tax offset of 16.5% tax. However, the whole-of-income-cap will stop her getting this ETP tax offset on the remaining $50,000 lump sum benefit because her other taxable income of $200,000 is greater than $180,000. As a result, she will pay the highest marginal tax rate on this $50,000.

These rules become absurdly complicated when you receive multiple termination payments or payments that are partly assessed under the whole-of-income-cap amount and partly excluded from it.

In relation to these complex rules, I don’t believe investors or financial advisers will be able to accurately work out how much tax they should be paying, especially if they receive several employment termination payments. In reality you’ll have to rely on the ATO retaining accurate records and hopefully performing these calculations correctly for you.

A system this complicated cannot possibly be fair.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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