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Tax free redundancy payments - even for directors closing a business

Payments to terminated employees can be tax free in some circumstances — including for directors who close the company's business and bring their own employment to an end. The ATO has given its interim view on what is required for these payments to be a 'genuine redundancy payment' which can be tax free. Paul Ellis

What is the Draft Ruling about?

A new draft ATO ruling clarifies when a genuine redundancy payment can be tax free (up to the relevant limit). The limit is worked out under section 83—170 of the Income Tax Assessment Act 1997.

The ATO's views in the Draft Ruling apply to many different circumstances. Of particular interest to some ClearLaw readers will be the tax treatment of payments to company directors who decide to sell, or close down, the company's business and so bring their own employment to an end.

The ruling is in Draft Taxation Ruling TR 2008/D6 (Draft Ruling).

What are the requirements for a payment to be a genuine redundancy payment?

There are 4 requirements for a genuine redundancy payment:

  1. The payment must be received in consequence of a termination — see Tax Ruling TR 2003/13. In summary, 'a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer 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.'.
  2. The termination must involve the employee being dismissed from employment — see below.
  3. The dismissal must be caused by the redundancy of the employee's position — redundancy must be the only reason for the termination. The employer must not want that person's job to be done by anyone.
  4. The payment must be made genuinely because of the redundancy — rather than being treated as a redundancy payment merely to achieve tax free status.

What sort of "dismissal" will qualify?

The ATO's view is that the dismissal of the employee:

  • must be because the employer has no other suitable job available for the employee. An exception is someone who has more than one capacity with the employer — for an example, as director of the employer and as a common law employee. These employees are called dual capacity employees. If either of their roles is terminated, then that will be a valid dismissal.
  • must be an act of the employer done without the consent of the employee. So if an employee resigns, retires, or has a choice as to whether or not to be terminated then that would not be a dismissal. However, an employee who indicates that they would be interested in their position becoming redundant can still be dismissed, so long as the final decision is with the employer.

How are directors etc. are treated? ("dual capacity employees")

As a director (or any "dual capacity employee") a person can often influence the decision as to whether their own employment should be terminated. This potential to influence the decision threatens the requirement discussed above, that the termination must be without the employee's consent.

However, the ATO considers that if the employer's act or decision that leads to the termination is dictated by legal or economic compulsion, then the dismissal will be a valid dismissal and the payment will be treated as a genuine redundancy.

The ATO gives a number of examples in which it indicates whether a director's (or other dual capacity employee's) participation in a decision to terminate his or her employment will or won't result in a genuine redundancy. The ATO's examples make it clear that:

  • being involved in a decision to sell the business of an employer will ensure that a payment after termination of employment will not be a genuine redundancy payment, but
  • closing down a business in declining economic circumstances is more likely to result in a genuine redundancy.

Further conditions

There are further conditions for a genuine redundancy, which must be kept in mind. Particularly relevant to a dual capacity employee is the arm's length requirement — the termination payment must not be more than could reasonably be expected in an arm's length relationship.

Normally the arm's length limit on a payment would be the amount of redundancy payments the employee is entitled to under the law. — But the employer may still be able to pay an ex gratia tax free redundancy payment as a genuine redundancy payment if:

  • there are no contractual or other legal obligations on an employer to pay redundancy entitlements; and
  • an ex gratia payment could be expected if the arrangements were negotiated at arm's length.

However, if the employee receives a payment that is greater than what could be expected, then the whole payment is disqualified from being a genuine redundancy payment.


The ATO has invited comments on the Draft Ruling to the ATO by 10 October 2008.


Lawyer in Profile

Paul Ellis
Paul Ellis
Special Counsel
+61 3 9258 3524

Qualifications: LLB, Deakin University, BA (Political Science), Monash University

Paul is a Special Counsel in Maddocks Government and Not-for-Profit Commercial team. He specialises in:

  • the establishment, governance, operations, regulation and administration of charities and other not-for-profit entities,
  • in commercial arrangements for the procurement or supply of goods and services, including technology services, and
  • in compliance and enforcement activities undertaken by government agencies.

Paul is Maddocks' main authority in relation to the Personal Property Securities Act 2009.

He has an in-depth understanding of the government sector, as his experience prior to Maddocks includes 13 years with the Victorian Department of Justice.

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