The AAT has rejected the Federal Commissioner of Taxation’s (Commissioner) view that a discretionary payment received by an employee upon his termination should be taxed as ordinary income. Despite the payment being made upon the termination of the employee the Commissioner argued that it was received in respect of their employment as it was calculated in relation to fees earnt. The Tribunal disagreed, noting that the formula used to calculate the payment and the fact the amount was labelled as ‘wages’ on the employee’s payslip did not alter the reason for the payment.

Background

In the case, VDGW and Commissioner of Taxation (Taxation) [2020] AATA 3745 the taxpayer’s role became redundant and his employment was terminated. The taxpayer received a payout from his former employer following the termination. The payout comprised two payments as follows:

the first was labelled in his payslip as ‘base salary’ for the pay period leading up to his termination; and
the second was labelled in his payslip as ‘wages’, described by the parties as a commission or an ex gratia payment and in the taxpayer’s redundancy letter it was noted as a ‘severance package’. The payment was calculated with reference to fees earnt by the taxpayer during his employment and noted in his contract of employment as a commission.

The Dispute

There was no dispute as to the tax treatment of the first payment. The dispute related only to the second payment. The taxpayer argued that the second payment should receive concessional tax treatment as either:

a genuine redundancy payment pursuant to section 83-175 of the Income Tax Assessment Act 1997 (ITAA 1997); or
an employment termination payment under section 82-130 of the ITAA 1997.

Under the ITAA 1997 a payment needs to have a causal connection with the termination of the employment of the taxpayer to be a genuine redundancy payment under s 83-175 of ITAA 1997 or an employment termination payment under s 82-130 of ITAA 1997.

In Taxation Ruling 2003/13, the Commissioner adopts a narrow interpretation of these provisions. The Commissioner is of the view that a payment is made in consequence of the termination of the employment if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

The Commissioner argued that the second payment in this matter was ordinary income as it was calculated in relation to fees earnt. The Commissioner asserted that the taxpayer would have received the second payment under the contract of employment as a commission if he had remained employed and therefore a causal connection could not be drawn between the payment and the termination.

Decision

The AAT found that there was a causal connection between the termination of the taxpayer and the second payment. Whilst the amount of the payment was referable to fees generated during the taxpayer’s employment, this made no difference to the nature of the payment. The Tribunal noted:

under the terms of the contract the employer was required to pay any amount upon termination. The decision to pay any amount is referable to the termination clause of the contract;
the fact that the same amount would have been paid as salary if the contract had continued made no difference as subsequent to the termination the obligation to pay that amount ceased. Any payment of the amount therefore related to the termination; and
whilst the payment was labelled as “wages” in his payslip it would be a mistake to substitute labels applied in a software package or by a bookkeeper for the substance of the agreement between the parties.

Key Issues to Note

This case arose due to the ability of the employer to retain discretion, under its employment contracts, to provide departing employees with certain payouts. In many employment contracts such a payout would be a question of entitlement and the tax consequences may be more readily determined. In the case of discretionary payments care should be taken to understand the true nature of such a payment.

This case serves as an important reminder for a number of taxpayers –

I am an employee who has received a redundancy payment, what are the tax consequences? You should carefully consider the nature of the payment/s received and ensure, where appropriate, concessional treatment is applied. If this cannot be easily gleaned from your payslip, severance letter and contract, seek professional advice.
I am negotiating a new Executive Employment Agreement, what tax considerations should be made? Executive Employment Agreements often contain complex termination clauses. The tax consequences of these payments and others under the agreement should be carefully considered as part of the negotiation phase. Discretionary payments may cast doubt in certain circumstances and therefore clearly drafted clauses should be a priority. We recommend seeking professional advice to review your employment agreement prior to execution;
I am an employer considering terminating staff. What do I need to know? Beyond the tax issues this case highlighted a number of tensions that can arise between an employer and employee as a result of termination. The Tribunal noted that communications between the parties contained “patent nastiness” as parties threatened lawsuits over payments. If you are intending to terminate staff contact one of our experienced employment lawyers here to understand your rights and obligations and receive strategic assistance to minimise and manage the risk of disputes.

To discuss further or for more information on the taxation of employment termination payments or general tax queries, please contact:

Laura Spencer
Senior Associate
M 0436 436 718 | T +61 3 9611 0110
E: lspencer@sladen.com.au

Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327| T +61 3 9611 0105
E: dsmedley@sladen.com.au

Lucy Liang
Graduate Lawyer
E lliang@sladen.com.au