Managing people

Employee termination payments

An employment termination payment (ETP) is a lump sum paid by an employer following termination of an employee.

An employment termination payment (ETP) is a lump sum paid by an employer to an employee following termination of the employee's employment. A payment made because of the death of an employee (a ‘death benefit termination payment’) is also treated under tax laws as a payment made because of the termination of employment.

An ETP is taxed at lower rates than ordinary income. Payment of an ETP also imposes on an employer obligations that differ from those that apply when ordinary income is paid.

Types of employee termination payments

The following payments are considered ETPs if paid because of termination of employment:

  • unused rostered days off
  • in lieu of notice
  • unused sick leave
  • a gratuity or golden handshake
  • compensation for loss of job
  • compensation for wrongful dismissal
  • genuine redundancy and approved retirement scheme payments in excess of the tax-free amount
  • a death benefit paid to another person when an employee dies.

An employer who pays a lump sum on termination of employment must decide if any part of the lump sum payment is considered an employment termination payment (ETP) (see s 80-130 Income Tax Assessment Act 1997). 

Payments that are ETPs are taxed differently from other kinds of payments made on termination of employment.

Genuine redundancy payments and early retirement scheme payments are tax-free up to the limit calculated by a set formula. The amount paid over this limit is the excess amount which is an ETP payment. The following amounts are not ETPs even if paid on termination of employment:

  • unused annual or long service leave payments
  • salary, wages or allowances
  • compensation for personal injury
  • payment for restraint of trade
  • the tax free amount of a genuine redundancy or early retirement scheme payment
  • certain advances or loans.

If an ETP contains an invalidity component, that amount is tax-free. An invalidity payment is calculated as the amount of a payment that is specifically intended to compensate the employee for having to retire early because of invalidity.

Rules for paying employee termination payments

Generally speaking, employment termination payments need to be received by an employee within 12 months of the termination.

An employee termination payment summary must be given for each payment. The employer must give the employee two copies of the ETP payment summary within 14 days of payment, and must send the amount withheld to the ATO with the employer’s PAYG payments.

The employer must pay the employee the net amount of the cash payment. This is the gross amount of the ETP less the amount withheld. Withholding rates are set out below.

Usually, the only component from which the employer needs to withhold amounts is the taxable component. The exception is if the employee has not provided a tax file number (TFN) for taxation purposes. In that case, tax must be withheld from the total benefit at the top marginal rate.

Read more about paying and recording ETPs here.

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Tax withholding rates for ETPs

The tax rate of an ETP depends on if it is:

  • a life benefit termination payment received by a person because of the termination of their employment, or
  • a death benefit termination payment received by a person after another person’s death.

In the case of a life benefit termination payment, the taxable component is taxed at ordinary tax rates but the recipient may be entitled to a tax offset that puts a ceiling on the rate that may apply. The amount to be withheld from the taxable component depends on the age of the employee.

The amount to be withheld from the taxable component depends on the age of the employee.

If anemployee is aged at least 55 years, the tax withheld cannot exceed 16.5% on the amount up to the low rate cap and amounts in excess of the low rate cap are taxed at the top marginal rate.

If the employee is aged less than 55 years, the tax withheld cannot exceed 31.5% up to the low rate cap amount and amounts in excess of the low rate cap are taxed at the top marginal rate.

The maximum 16.5% tax rate on the amount up to the low rate cap amount generally applies each time an employee receives a termination payment from an employer. The exception is that the cap is reduced by the amount of an ETP already received by the employee in that same year or received by the employee, in that or an earlier year, for the same termination.

In the case of a death benefit termination payment, if the payment is made to a dependant of a deceased employee, no tax is withheld from: (a) the tax free component, or (b) the taxable component up to the low rate cap amount. The amount of the death benefit above the low rate cap amount is taxed at the top marginal rate.

If an employer pays a death benefit termination payment to a non-dependant: (a) no tax is payable on the tax free component, (b) the amount of the taxable component up to the low rate cap amount is taxed at 31.5%, and (c) the amount in excess of the low rate cap amount is taxed at the top marginal rate.

Tax must be withheld at the top marginal rate, including from the tax free component, where a TFN has not been provided.

Calculating the components of an ETP

ETPs are made up of two components:

  • a tax-free component, which is made up of the invalidity component (described above in ‘Types of employee termination payments’) and the amount from any service period before July 1983, and
  • the taxable component, which is the remainder of the ETP.

An ETP will only have a tax-free component if the employee leaves work early because of invalidity, or if the employee began work with the employer before 1 July 1983. An ETP will always have a taxable component.

Calculation of these two components is based on the employee’s 'service period' with the employer.

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