Termination payments cause a lot of confusion for employers. Here are five things you need to know about how to process an employment termination payment.
1. What exactly is an ETP?
Firstly, an employment termination payment (ETP) is a payment given to an employee as a result of their terminating employment.
However, it does not include payments for unused annual and long service leave entitlements. Additionally, some payments on termination receive a tax-free component based on the employee’s length of service.
It is only the amount above the tax-free portion that is an ETP and not the entire payment. In the event that the tax-free component is equal or greater than the payment, there is in fact no ETP.
Furthermore, once you have established that there is an ETP, it may be that the ETP has a tax-free component and a taxable component. The tax-free component is representative of pre-July 1, 1983 service and/or invalidity segment.
2. What do the two ‘Caps’ represent?
There are two caps, the ‘ETP Cap’ and the ‘Smaller of the ETP or Whole of Income Cap’. The ETP Cap applies to ETP life benefit payments made because of genuine redundancy, early retirement, invalidity and compensation payments as well as Death Benefit Payments.
The Smaller of the ETP Cap or Whole of Income Cap applies to ETPs made when the employee leaves for other reasons, such as resignation, dismissal due to poor performance etc. The ETP Cap and the Whole of Income Cap are both $180,000 for the 2013-14 financial year, however the ETP is indexed at $5000 each year.
The Whole of Income Cap is fixed at $180,000, in line with the current highest tax bracket. The ETP is independent of the employee’s assessable income while the Whole of Income Cap incorporates the employee’s assessable income when taxing the ETP.
In order to determine the correct tax treatment, you must establish why the payment is being made.
3. Why is the payment being made?
Understanding why the payment is being made and what the amounts represent is the key to determining the tax treatment of an ETP. For example, a payment in lieu of notice made to an employee on termination would most likely be taxed differently if the reason for termination was resignation as opposed to genuine redundancy.
Furthermore, some situations on termination require many have multiple ETPs that are taxed under the different caps. For example, in a redundancy situation, the redundancy payment would be taxed under the ETP Cap while unused RDOs for the same employee would be taxed under the Smaller of the ETP or Whole of Income Cap.
4. Why is the employee’s date of birth important?
The correct tax rate to apply to ETPs is dependent on the employee’s age. The Tax Office advises the applicable tax rate on ETPs is 16.5% for employees over preservation age and 31.5% if the employee is under preservation age.
Any remainder over the relevant cap is taxed at 46.5%. The employee preservation date is determined using the employee’s date of birth. If the employee was born before July 1, 1960 the preservation age is 55. Preservation age then increases each subsequent year until June 30, 1994 where, for any employee born after this date, the preservation age is 60.
5. Producing the ETP payment summary correctly
Once the ETP has been calculated and processed correctly, it is just as important to ensure the reporting of these payments on the ETP payment summaries is correct. The ETP payment summary requires reason codes to be populated. If these are incorrect, it could result in a tax liability for the employee.
Termination payments are some of the most complicated in payroll. For any specific questions, please email me at [email protected]