HOUSE OF REPRESENTATIVES

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon. John Dawkins, M.P.)

Chapter 5 - Taxation of redundancy, early retirement and invalidity payments

Summary of proposed amendments

Purpose of amendment:

To provide a limit on the concessionally taxed amount of bona fide redundancy payments and approved early retirement scheme payments.

To exempt amounts within that limit from tax.

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To prevent bona fide redundancy payments and approved early retirement scheme payments being paid from a superannuation fund.

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To modify the meaning of invalidity payment and to require verification of the recipient's disability by two legally qualified medical practitioners.

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To create a new ETP component comprising invalidity payments made on or after 1 July 1994 (the post-June 1994 invalidity component).

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To exempt the post-June 1994 invalidity component from tax.

Date of Effect: 1 July 1994

Background to the legislation

What is a BFRP, AERSP and invalidity payment ?

An eligible termination payment (ETP) may comprise various components which are subject to different rates of tax. One such component is the concessional component, which consists of or is attributable to one or more of the following payments.

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A bona fide redundancy payment (BFRP). This is a payment received on redundancy which exceeds the amount that could reasonably be expected to have been received if the employee had voluntarily retired at the same time.

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An approved early retirement scheme payment (AERSP). An approved early retirement scheme is a scheme approved by the Commissioner of Taxation providing for early retirement of a specified class of employees with a view to rationalising or re-organising the operations of the employer. A payment made under such a scheme is an AERSP to the extent that it exceeds the amount that could reasonably be expected to have been received if the employee had voluntarily retired at the same time.

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An invalidity payment. This is the future service component of an ETP (based on prospective service to usual retirement age) paid to an employee as a consequence of his or her physical or mental incapacity to engage in the particular employment. For payments made on or after 1 July 1994, the Bill proposes that the employee's incapacity must render the employee incapable of ever being employed in a capacity for which he or she is reasonably qualified.

BFRPs and AERSPs from superannuation funds

BFRPs and AERSPs are distinguishable from ordinary retirement payments from superannuation funds. In this regard, any part of an ETP made in lieu of superannuation benefits to which the employee may have become entitled at some later date is treated as an amount which an employee could reasonably be expected to receive on voluntary retirement at a particular time. It is rare, therefore, for any payment from a superannuation fund to contain a BFRP or an AERSP. However, in Case Y39 91 ATC 382 (AAT Case 7211 (1991) 22 ATR 3337) it was recognised that in some circumstances a payment from a superannuation fund does qualify as a BFRP or AERSP.

Calculation of superannuation benefits to which the employee may have become entitled at some later date may be complicated when the payment is from a superannuation fund. To simplify the distinction between BFRPs or AERSPs and ordinary retirement payments from superannuation funds, the Bill proposes to exclude superannuation fund payments from the definitions of AERSP and BFRP.

What is the current taxation treatment of BFRPs, AERSPs and invalidity payments ?

BFRPs, AERSPs and invalidity payments comprise the concessional component of an ETP, 5% of which is included in assessable income.

Taxation can be deferred by rolling over the concessional component into a roll-over fund (for instance, a deferred annuity or an approved deposit fund). The component retains its identity in the roll-over fund so that subsequent withdrawals may contain the concessional component.

The concessional component does not count against the recipient's reasonable benefit limit (RBL).

What limit is there on BFRPs and AERSPs?

Currently there is no limit on the amount of a BFRP or AERSP that can receive concessional tax treatment. This provides scope for abuse by people able to manufacture the necessary circumstances.

To counter that abuse, from 1 July 1994 there is to be a limit on the concessionally taxed amount of BFRPs and AERSPs. This limit is called the tax-free amount.

The limit will accommodate the majority of genuine payments while limiting the scope for abuse.

What are the new taxation arrangements for BFRPs, AERSPs and invalidity payments ?

The tax-free amount of a BFRP or AERSP will not form part of an ETP and is to be exempt from income tax and capital gains tax. Amounts in excess of the limit will be taxed as an ordinary (non-concessional) ETP from an employer.

The tax-free amount cannot be rolled over and does not count against the recipient's RBL. Roll-over relief is not required because, on re-employment, the tax-free amount can be made as a contribution to a superannuation fund and received free of tax as undeducted contributions on retirement (provided no tax deduction was claimed for the contribution).

The taxation of invalidity payments will also be simplified and made more beneficial for recipients by exempting them from income tax and capital gains tax. However, an invalidity payment remains part of an ETP and will constitute a separate ETP component (the post-June 1994 invalidity component).

The post-June 1994 invalidity component will not be assessable against the recipient's RBL. However, it will be able to be rolled over to enable the recipient to retain the benefit in a concessionally taxed environment (even if the recipient is unable to work again and contribute to a superannuation fund).

What is the new test for invalidity payments ?

Currently, in determining whether a payment is an invalidity payment, the employer is required to determine whether a person is physically or mentally incapable of engaging in the employment.

To clarify the test for incapacity and to place the onus of determining invalidity on legally qualified medical practitioners, from 1 July 1994 the incapacity of a person will have to be certified by two medical practitioners.

The relevant test is also to be modified so that the invalidity payment concession is extended only to people who are unable to undertake any form of employment for which they are reasonably qualified. A person who is unable to continue his or her current employment, but is able to undertake other appropriate employment, will not have access to the concession.

The proposed test is consistent with that used in the Occupational Superannuation Standards Regulations for RBL purposes, and is the same as the test proposed by clause 19 of the Bill for the definition of death or disability benefits in subsection 1595J(1).

Explanation of proposed amendments

Limit on the concessionally taxed amounts of BFRPs and AERSPs

The limit on the concessionally taxed amount of BFRPs and AERSPs proposed by the Bill is to be defined in new subsections 27A(19)-(21) as the sum of:

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$4000 for the 1994/95 income year, indexed to rise in subsequent years in line with increases in average weekly ordinary-time earnings; and

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$2000 for each whole year of completed service with the

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employer concerned, also indexed to rise in years after 1994/95 in line with increases in average weekly ordinary-time earnings.

[Subclause 50(d) - new subsections 27A(19)-(21)]

The relevant period of completed service is the same as the period defined in paragraph (a) of the definition of eligible service period in subsection 27A(1). That is, the period, or aggregate of the periods, of the employment to which the payment relates. However, eligible service period is expressed in days, while the service period for subsection 27A(19) purposes is expressed in whole years.

The amount by which the limit increases each year due to indexation will be calculated and announced each year by the Commissioner of Taxation.

The Bill defines the amount of a BFRP or an AERSP within the limit as the tax-free amount. [Subclause 50(c) - new definition in subsection 27A(1)]

Taxation arrangements for the tax-free amount

The tax-free amount of a BFRP or AERSP is excluded from the ETP definition. Therefore it cannot be taxed as an ETP. [Subclause 50(a) - new paragraph (ja) in the ETP definition in subsection 27A(1)]

However, in some cases a BFRP or an AERSP might be income according to ordinary concepts, or constitute a net capital gain within the provisions of Part IIIA of the Act. To ensure that the tax-free amount is not assessable under any provision of the Act, the Bill proposes to exempt that amount from income and capital gains tax by:

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excluding the tax-free amount from assessable income;

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and requiring the tax-free amount to be ignored when calculating whether a capital gain accrues to a taxpayer.

[Clause 53 - new subsection 27CB(1)]

Fringe benefits tax will not apply to any part of a BFRP or AERSP because paragraph (f) of the definition of fringe benefit in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 specifically excludes salary or wages (which, for these purposes, includes payments made by way of superannuation, pension or retiring allowances).

Roll-overs and RBLs

Since the tax-free amount is excluded from the ETP definition, it cannot be rolled over and will not count towards the recipient's RBL.

Tax avoidance

Schemes entered into to split a BFRP or AERSP in an attempt to obtain two or more tax-free amounts when there would otherwise only be one tax-free amount will be subject to Part IVA of the Act.

Taxation of the excess

If the BFRP or AERSP paid on or after 1 July 1994 exceeds the tax-free amount, the excess will be treated as an ordinary ETP (i.e. the tax-free amount will be disregarded and the excess will be split into its components as an ETP without a concessional component).

Example

Bob commenced employment with Betty in July 1970. In August 1990 Bob took 2 years leave without pay. Bob recommenced employment in September 1992. He was made redundant in June 1995.

In view of his loyal service over the years, Betty paid him an ex-gratia payment of $50,000 in addition to his accrued superannuation benefits. The $50,000 is a BFRP.

The number of whole years of service to which the payment relates is:

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20 years from July 1970 - August 1990; and

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2 years from September 1992 to June 1995.

Therefore, the tax-free amount of the payment is:

$4,000 + [$2,000 x 22] = $48,000.


The remaining $2,000 will be split into the pre-July 1983 component and the post-June 1983 component based on Bob's eligible service period and taxed accordingly. Bob could elect to defer taxation on the $2,000 by rolling it over.

Preventing BFRPs and AERSPs being paid from superannuation funds

The Bill inserts new paragraphs into the definitions of AERSP and BFRP in sections 27E and 27F respectively. The new paragraphs indicate that, as from 1 July 1994, a payment from an eligible superannuation fund cannot be a BFRP or an AERSP. [Clauses 55 and 56 - new paragraphs 27E(4)(aa) and 27F(1)(aa)]

An eligible superannuation fund (defined in subsection 27A(1) by reference to its meaning in Part IX of the Act) is a complying or a non-complying superannuation fund.

A payment from an eligible superannuation fund includes a payment not actually made from a fund but which is, in effect, funded from an eligible superannuation fund (subsection 27A(17)). Therefore, if a superannuation fund payment is paid to an employee through the employer, then, as from 1 July 1994, the payment cannot be a BFRP or AERSP.

Modification of invalidity payment test

A payment made on or after 1 July 1994 will only be an invalidity payment if two legally qualified medical practitioners have certified that the disability of the employee is likely to result in the employee being unable ever to be employed in a capacity for which he or she is reasonably qualified by virtue of the employee's education, training or experience. [Clause 57 - new subparagraph 27G(b)(i)]

Creation of new post-June 1994 invalidity component

The proposed tax treatment of invalidity payments made on or after 1 July 1994 is different from the tax treatment of the concessional component of an ETP. Therefore the Bill proposes to create a new component, the post-June 1994 invalidity component.

The post-June 1994 invalidity component is to be defined in subsection 27A(1). It is so much of an ETP as consists of or is attributable to an invalidity payment, as defined in section 27G, made on or after 1 July 1994. [Subclause 50(c) - new definition in subsection 27A(1)]

Reference to the new component is to be inserted in subsection 27AA(1), which depicts the possible components of an ETP. This will indicate that an ETP paid on or after 1 July 1994 may contain the component. [Subclause 51(a) -new paragraph 2 7AA (1) (aa)]

Subsection 27AA(1) is also to be amended to provide for the calculation of the pre-July 1983 component of ETPs containing the post-June 1994 invalidity component. For these purposes, the post-June 1994 invalidity component will be treated in the same way as the concessional component, so that from 1 July 1994 the pre-July 1983 component is the lesser of the following amounts:

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the amount of the ETP reduced by the concessional component, the post-June 1994 invalidity component, the non-qualifying component and the excessive component, multiplied by the proportion of pre-July 1983 service to total eligible service period; and

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the amount of the ETP reduced by the concessional component, the post-June 1994 invalidity component, the non-qualifying component, the excessive component and the undeducted contributions.

[Subclauses 51 (b) and 51 (c) - amended paragraph 2 7AA (1) (d)]

The taxation of an ETP depends on which of its components have been retained (i.e. not rolled over). Section 27AC (to be inserted by clause 53, as explained in Chapter 4) identifies the components of an ETP which are retained. Section 27AC is to be amended to provide for the calculation of the retained components of an ETP containing the post-June 1994 invalidity component in the following way:

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the retained amount of the post-June 1994 invalidity component is so much of that component as has not been rolled over; [Subclause 52(a) - new paragraph 27A C(2)(ba)]

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corresponding to the calculation of the pre-July 1983 component of an ETP under subsection 27AA(1) (explained above), the retained amount of the pre-July 1983 component is to be calculated by treating the post-June 1994 invalidity component in the same way as the concessional component, so that the retained amount of the pre-July 1983 component is the lesser of the following amounts:

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the retained amount of the ETP reduced by the retained amount of the concessional component, the post-June 1994 invalidity component, the non-qualifying component and the excessive component, multiplied by the proportion of pre-July 1983 service to total eligible service period; and

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the retained amount of the ETP reduced by the retained amount of the concessional component, the post-June 1994 invalidity component, the non-qualifying component, the excessive component and the undeducted contributions; [Subclause 52(b) -amended paragraph 27A C(2)(d)]

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the retained amount of the post-June 1983 component is to be calculated by excluding the retained amount of the other components, including the post-June 1994 invalidity component, from the total ETP retained.

[Subclause 52(c) - new subparagraph 27AC(2)(e)(ia)]

Taxation arrangements for the post-June 1994 invalidity component

To ensure the post-June 1994 invalidity component is not assessable under any provision of the Act, the Bill proposes to exempt the component in the same way it exempts the tax-free amount of BFRPs and AERSPs; namely by:

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excluding the post-June 1994 invalidity component from assessable income; and

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requiring the component to be ignored when calculating whether a capital gain accrues to a taxpayer.

[Clause 53 - new subsection 27CB(1)]

As with BFRPs and AERSPs, fringe benefits tax has no application to invalidity payments.

New sub-subparagraph 27D(1)(b)(iii)(E) will enable taxpayers to specify the extent to which they wish to roll over the post-June 1994 invalidity component [Subclause 54(a) - new sub-subparagraph 27D(l)(b)(iii)(E)].

The amount of post-June 1994 invalidity component specified by the taxpayer as forming part of the applied (rolled-over) amount of an ETP is called the notional post-June 1994 invalidity component [Subclause 54(b) - new paragraph 2 7D (5) (aa)].

The notional post-June 1994 component needs to be taken into account in calculating the notional pre-July 1983 component. As explained in Chapter ##, the notional pre-July 1983 component is calculated according to the formulae prescribed in paragraph 27D(5)(c). Those formulae provide calculations based on the applied amount of the ETP reduced by the notional concessional component. For these purposes, the post-June 1994 invalidity component is to be treated in the same way as the concessional component. Therefore the formulae in paragraph 27D(5)(c) are to be amended so that, in determining the notional pre-July 1983 component, the applied amount of the ETP is reduced by the notional post-June 1994 invalidity component as well as the notional concessional component. [Subclause 54(c) - amended paragraph 27D(5)(c)1

Saving of concessional component

Although original ETPs paid on or after 1 July 1994 will not include a concessional component, an ETP paid from a roll-over fund after that date may still include a concessional component. For instance, an ETP received before 1 July 1994 containing a concessional component may be rolled over and withdrawn from the roll-over fund after 1 July 1994. The concessional component will continue to be represented in the ETP withdrawn from the fund because the payment will be attributable to a BFRP, AERSP or invalidity payment made before 1 July 1994.

Therefore the current references to the concessional component in the Act are to remain.

However, it is necessary to distinguish payments made before and after I July 1994. Therefore the definition of concessional component in subsection 27A(1) is to be amended by inserting the requirement that the BFRP, AERSP or invalidity payment be made before 1 July 1994. [Subclause 50(b) - amended concessional component definition in subsection 27A(1)]