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1 The Increased Tax on Lump Sum Termination Payments By Ray Stevens (USA) INTRODUCTION In May, 1983, the Government announced increases in the taxation payable on lump sum superannuation benefits and on certain lump sum payments by employers. After some significant modifications to the original proposals, the Bill to implement the changes was presented to Parliament on 30th May, 1984 and became law on 25th June, However, most of its provisions are effective from 1st July, Lump sum payments to which the new arrangements apply include the following where payment was made on or after 1st July, 1983: From Superannuation Funds (whether employer-sponsored or not) - on age retirement - on invalidity retirement - on resignation or dismissal - on termination due to redundancy - on portion of death benefit where included in estate not distributed solely to dependants - on commutation of a pension - residual payments on termination of a pension - other lump sum payments permitted by fund rules From Employers - on retirement ("golden handshakes") - on redundancy (severance payments) - contractual termination payments - in lieu of unused sick leave - in compensation for loss of office or employment From Other Sources - on withdrawal from "approved deposit fundsw (to be set up as part of the new arrangements) - on commutation of an annuity - residual payments on termination of an annuity. The legislation refers to these payments as "Eligible Termination Payments", presumably because they are eligible to be taxed under the new rules. This paper concentrates on lump sum benefits paid from employer-sponsored superannuation funds, but similar principles apply to the other payments.

2 PRINCIPLE BEHIND THE CHANCES The principle behind the changes is that all income from employment should be taxed, but only once. Salary and wage payments are taxed at the time they are made. With superannuation, however, timing differences between the provision of the,income and the receipt "of the income create alternative methods of imposing tax. e.g (1) (2) i When an employer contributes to a fund for the future benefit of an employee, tax can be imposed either by including the contribution in the employee's income when the contribution is paid, or by taxing that part of the benefit when the benefit is paid. Investment income can be taxed when earned by the fund, or the part of a benefit arising from investment income can be taxed when the benefit is paid. This principle is not new and applies in most Western countries. In Australia it has applied in the past to pension benefits. No tax has been imposed when an employer contributes to a fund or when a fund earns investment income, but when the employee retires and receives a pension, the pension income has been taxed. However, in Australia we have previously had the almost unique provision for the whole of a retirement benefit to be taken as a lump sum. Only 5% of such a benefit has been included in taxable income, so that when the maximum marginal tax rate has been 60%, the maximum tax which could be incurred has been 3% of :he benefit. Some countries have taxed lump sums lightly, but placed restrictions on their availability. The main change introduced by t he new legislation is to impose a much higher tax on lump sum benefits. In applying the above principle, the following concessions have been allowed: Benefits attributable to periods of employment prior to 1st July, 1983 will continue to be taxed on the old 5% basis. Most death benefits will continue to be exempt from tax. Part of a benefit paid because of redundancy, invalidity retirement, or retirement under a special early retirement scheme, will be taxed on the old 5% basis. The maximum tax rate imposed is 30%, rather than the employee's marginal tax rate if greater.

3 CALCU LATION OF THE TAX Any lump sum termination payment received on or after 1st July, 1983 from an employer or an employer-sponsored fund will be split into the following components and taxed on the basis shown: COMPONENT A. Part attributable to employment prior to 1st July, 1983, other than the portion included in C B. Amount contributed by employee after 30th June, 1983 C. Increase due to redundancy or special early retirement scheme D. Part attributable to employment after 30th June, 1983, other than B and portion included in C E. Part of Invalidity benefit attributable to potential employment period lost because of invalidity retirement. TAX BASIS 5% included in taxable income Exempt 5% included in taxable income Taxed at 30%, except that first $50,000 of this component received after age 55 is taxed at 15% 5% included in taxable income Employee contributions after 30th June, 1983 are exempt on the principle that these have been paid out of income which has already been taxed and the amount must not therefore be taxed again. The fact that in some cases a rebate may have been obtained for part of the contributions is ignored. (Exemption does not apply to contributions paid under personal superannuation arrangements by self-employed persons, or employees not covered by an employer-sponsored fund, where a tax deduction has been allowed for those contributions.) THE BEFOREIAFTER 1ST JULY, 1983 SPLIT For an employee who commenced employment prior to 1st July, 1983, the benefit is split into its components pro rata to the periods of employment before 1st July, 1983 and on and after 1st July, Each period is measured in days. (Under personal superannuation arrangements, the split is based on the periods of membership of the fund.)

4 The Commissioner has discretion to increase, but not reduce, the amount attributed to employment before 1st July, 1983 by this formula, having regard to the dollar amount of the benefit accumulated or accrued at that time. This could be relevant in cases.where the benefit does not accrue evenly - e.g. due to a change from full-time to part-time employment, or in schemes which allow members a choice of contribution levels with the opportunity to switch from one level to another from time to time. If a resignation benefit is being paid, the Commissioner will have regard to the resignation benefit at If a redundancy benefit is being paid, the Commissioner will have regard to the redundancy benefit at In the case of a retirement benefit he will have regard to the notional retirement benefit at even though the employee may not then have reached an age at which a retirement benefit was available. A SIMPLE EXAMPLE Consider an employee who retires and receives a lump sum benefit from the employer's superannuation fund and to whom the following particulars apply: Employment Commenced: 1/7/1973 Joined Superannuation Fund: 1/7/1975 Age at Retirement: 60 years Retirement Date 30/6!2003 Benefit Received: $90,000 Employee Contributions after : $20,000 Marginal Tax Rate: 30% This employee was in service for 30 years in all, of which 10 years were prior to 1/7/83 and 20 years were subsequent to that. Note that the date of joining the superannuation fund is not relevant. Also note these periods of service must in practice be calculated in days, but years have been used here to illustrate the principles, and that where the benefit is not paid on the date of retirement the period between that date and the date of payment must generally be included in the period of "service". The calculation of the tax is as follows: COMPONENT A - Pre portion: = x $90,000 = $30,000 - TAX B - Employee contributions after : = $20,000 Nil D - Post taxable portion: = (20130 x $90,000) - $20,000 = $40,000 Total tax on new basis = $6,450 Total tax on previous basis = 30% x 5% x $90,000 = $1,350

5 The tax amounts shown above exclude the Medicare levy. In 1984/85 this would be: 1% of (5% of $30,000) + 1% of $40,000 = $415 Note that - ( i) (ii) (iii) (iv) The "date employment commenced" is not necessarily the date of commencing work with the current employer. Where there have been take-overs and acquisitions in the past, one can go back through reconstructions provided one does not go back beyond a point when a superannuation benefit was taken in cash - because that must have been the benefit for employment up to that point. Where a benefit is received after age 55, the 15% tax rate applies to the first $50,000 of Component D, not the first $50,000 of the total benefit. In this example the benefit is $90,000 but no part of the benefit is taxed at a rate higher than 15%. The 15% rate does not apply to the first $50,000 of &benefit, it applies to the first $50,000 (of Component D) of all benefits received after age 55. Benefits received from both the employer and the fund, and from other employers and funds must therefore be taken into account. It is possible for Component D to be negative, particularly in the next few years for cases where the employee did not join the fund until some years after joining service. In this event the negative balance is used to reduce Component A, so that an amount equal to employee contributions paid after 30/6/83 is always exempt from tax. BENEFITS ELIGIBLE FOR CONCESSIONS Redundancy Benefits The amount by which the benefit has been increased because termination was due to redundancy is eligible for concessional treatment. This does not necessarily mean the excess over the benefit the employee would have had theright to receive on voluntary termination. Where it has become established practice to use a discretion in a particular way, that must be allowed for. Where early retirement requires employer approval, but approval is in practice virtually automatic, only the excess over the early retirement benefit is eligible for concessional treatment. To calculate tax on a redundancy benefit, the portion eligible for concessional treatment (Component C) is first deducted from the benefit. The balance is then split into pre and post 1/7/83 portions pro rata to service in the manner shown in the earlier example.

6 Approved Early Retirement Schemes In recent years a number of employers have restructured or- reduced their staff by offering say all employees over a certain age special benefits if they elect to retire early within a specified period. The amount by which the early retirement benefit usually payable is increased under such a scheme is eligible for concessional treatment. Tax is calculated in the same way as for redundancy benefits. To qualify for the concessional treatment the scheme must satisfy three conditions: (i) The scheme must be open to all employees in a defined category - e.g. all employees over a certain age, all employees with a particular occupational skill, or all employees at a particular location. (ii) The scheme must have the aim of restructuring operations in some way - e.g. replacing employees with a particular skill with employees having a different skill, ceasing particular operations, or relocating operations. (iii) The scheme must have the prior approval of the Commissioner of Taxation as being an "approved early retirement schemet1. The Commissioner has some power to grant retrospective approval, par titularly for schemes implemented before the provisions became law on 25/6/84. 'Invalidity Benefits These benefits are given concessional treatment by including the period of potential service lost because of invalidity retirement when splitting the benefit into its components. As an example consider an employee who receives an invalidity retirement benefit of $90,000 at age 50, and who had 10 years of service prior to 1/7/83, 5 years of service after 30/6/83 and would have had a further 15 years of service had invalidity not prevented the employee continuing to the normal retiring age of 65. Assume employee contributions paid after 30/6/83 are $5,000 and the employee's marginal tax rate is 30%. The following calculation illustrates the principle behind the tax on an invalidity retirement benefit:

7 COMPONENT TAX A - Pre 1/7/83 portion: = x $90,000 = $30,000 B - Employee contributions after : = $5,000 Nil D - Post taxable portion: 30% x $10,000 = (5130 x $90,000) - $5,000 = $3,000 = $l0,000 E - Lost service portion: = 15/30 x $90,000 = $ Total tax on new basis = $4,125 Total tax on previous basis = 30% x 5% x $90,000 = $1,350 However, in practice the concessional component E is calculated using the period from the day after that on which the employee ceased active employment. The balance of the benefit is then split using the period of "service" including (generally) the period up to the date the benefit is paid. Accordingly the following calculation procedure must be used. In this case it has been assumed the benefit is paid on the day active employment ceases (30/6/88). This would be most unlikely to be the situation in practice but the figures illustrate that the tax would be identical to that shown abov; were it not for the two dates involved. COMPONENT E - Lost service portion: = 15/30 x $90,000 = $45,000 A - Pre 1/7/83 portion: = 10/15 x ($90,000 - $45,000) = $30,000 B - Employee contributions after : = $5,000 Nil D - Post taxable portion: = 5/15 x ($90,000 - $45,000) - $5,000 = $lo,ooo Total tax on new basis = $4,125

8 The definition of invalidity is termination "by reason of the taxpayer's physical or mental incapacity to engage in that employment". Benefits eligible for this concession will not therefore be limited to those meeting the typical "total and permanent disablement" definition included in superannuation fund trust deeds. Death Benefits Tax-exempt superannuation funds can only pay death benefits to the dependants of a deceased member or to the estate. Benefits paid to dependants are exempt from tax. For this purpose the spouse of the member and any child (regardless of age) of the member is automatically regarded as a dependant. However, where payment is made to the estate these may not be fully exempt from tax as in the past. The Commissioner has power to tax part of the benefit, having regard to the extent to which dependants are expected to benefit from the estate. Where tax is payable, the gross amount will be calculated in the same way as would apply to a termination payment. This will then be reduced by the Commissioner according to his view of the extent to which dependants will benefit from the estate. This unfortunate provision will create administrative problems for trustees, executors and the Taxation Office. Trustees are required to make PAYE tax deductions from a death benefit where it is paid to the estate. They can apply for per mission to deduct less than the gross amount by producing the will or other evidence of the manner in which the estate will be distributed. There is another unfortunate provision in respect of death benefits. Some funds provide for payment of a pension to :he spouse (andlor other dependants) when a member dies. If the spouse commutes this entitlement, the lump sum received will not be eligible for the same exemption as a lump sum death benefit. Instead it will be taxed in the same way as termination payments. If the fund rules are altered to give the spouse the choice between a lump sum benefit and a pension, the lump sum is exempt from tax. ROLL-OVER PROVISIONS AN D APPROVED DEPOSIT FU N DS The tax on all or part of a lump sum termination payment can be deferred by transferring ("rolling-over") the sum - (a) (b) into the superannuation fund of the new employer; or into an "approved deposit fund". The taxpayer has 90 days frorn the date of receipt of a benefit to effect a roll-over and thus avoid paying tax on the su m transferred. As a transitional arrangement, those who have received benefits since 1st July, 1983 have until 90 days after 25th June, This period expires on 23rd September, 1984, but is likely to be extended if a reasonable range of "approved deposit funds" has not become available by then.

9 Where a person transfers less than the full benefit, the person can nominate which parts of the sum transferred come from each of the components A, B, C and D described earlier. "Approved deposit funds" may be established by organisations such as life offices, banks, friendly societies, building societies, credit unions and trade unions. Provided the fund meets the prescribed requirements, its investment income will be tax free. This is not contingent on meeting requirements. Where a benefit is paid into an approved deposit fund, the depositor may withdraw all or any part of his credit at any time. Tax is paid on each withdrawal. This is calculated using the same procedure as the tax on a termination payment but counting the period the money has been in an approved deposit fund as well as the period of employment in splitting the benefit into its components. Where a benefit is "rolled-over" into the new employer's fund, the total benefit received on eventual termination of service is treated in aggregate for tax purposes. Both the period of employment with the old employer and that with the new employer are counted in splitting the benefit into its components. PENSIONS - COMMUTATIONS AND RESIDUAL PAYMENTS On cessation of a pension it is common to pay a lump sum where pension payments total less than (say) the member's contributions plus interest. These residual payments and amounts received on commutation of pensions are also subject to the new tax. When splitting the benefit into its components, the period during which the pension has been paid is counted. Where the pension had continued to the spouse or other dependant of a retired employee, this includes the period during which the pension was paid to the retired employee and the period of employment of the retired employee is also counted. PAYE REQUIREMENTS From 1st August, 1984, PAYE tax deductions must be made from any lump sum termination payment paid by a superannuation fund or an employer, unless the benefit is paid direct to another superannuation fund or to an approved deposit fund. Any person who makes 10 or more termination payments in any 12 month period commencing on or after 1st July, 1983 must, if not already registered, register as a group employer within 14 days of the end of that period. The first registrations were therfore due by 14th July, A person not required to register may elect to do so. The trustees of a superannuation fund may arrange for the sponsoring employer to act as their representative. This will probably be the most common option selected by small and medium size funds. The trustees must advise the tax office they have done this.

10 A life office or other organisation which administers one or more funds may also register as a representative of the trustees. The PAYE deduction will only apply to the part taxable on the 15%/30% basis. Deductions will actually be at rates of 16% and 31% to allow for the 1% Medicare levy. For payments after age 55, the trustees will not be required to take account of other payments which have been or are being paid in applying the 16% tax rate to the first $50,000. Any shortfall will be picked up in the employee's assessment. ANNUITIES AND PENSIONS Full details of these matters are outside the scope of this paper. The Government is trying to make the alternatives of taking a pension from a superannuation fund, or taking a lump sum and using it to buy an annuity, more attractive than in the past. Some of the changes made will reduce the tax paid by recipients of pensions and annuities. Other changes will assist organisations selling annuities to offer better terms. Those receiving pensions from a superannuation fund gain in two relatively minor ways: (a) (b) Previously the "undeducted purchase price" excluded employee contributions within the $1,200 per annum limit used for concessional expenditure rebate purposes. All employee contributions paid after 30th June, 1983 to an employer-sponsored fund will be eligible to be included. Of course an employee who commutes part of his pension entitlement may elect instead to use these to make part of his lump sum tax free. (Contributions paid under personal superannuation arrangements by self -employed persons, or employees not covered by an employer-sponsored fund, for which a tax deduction has been allowed, cannot be included in "undeducted purchase price".) When converting the "undeducted purchase price" to the equivalent annual amount, which becomes the portion of the annuity which is tax free, only the retired employee's expectation of life has been used, and the benefit of the deduction has ceased on the death of the retired ernployee even though pension payrnents might continue to the spouse or other dependants. In future the conversion will be based on a proper actuarial calculation of the period for which the pension is expected to be payable (based on standard life tables), and the deduction will be available for the full period during which the pension is payable. The second change will also benefit employees who take a lump sum and buy an annuity. However, whereas in the past the whole of the purchase price would in these circumstances be included in thevundeducted purchase price", this amount will in future exclude any part of the purchase price which comes from the component previously referred to as "D" - i.e. the portion which would be taxed on the 15%/30% basis if taken as a lump sum. This is consistent with the principle that this amount must be taxed at some stage.

11 " Changes which will assist sellers to offer better annuity terms are: (i) (ii) (iii) (iv) The investment income of that part of an organisation's funds which are related to annuities (other than deferred annuities not purchased with "rolled-overu lump sums) will be exempt from tax. The minimum valuation basis which required Life Offices to maintain unreasonably high reserves for annuity business will at last be changed. Indexed bonds will be made available to organisations selling annuities. The range of organisations which are permitted to sell annuities will be widened. The Government has also announced it proposes to alter the unfair treatment of annuities in the calculation of Social Security pension entitlements. It is likely that, as with taxation, part of the annuity will be treated as a return of capital and not counted as income. COST OF LIVING SUPPLEMENTS A number of employers with pension funds make ex-gratia supplementary payments to pensioners to compensate for all or some of the effects of increases in the cost of living. There have been disputes over whether such payments are taxable income, and recently taxpayers have had some success even where the payments have been quite regular. The revised legislation specifically provides that payments of this type made after 30th May, 1984 are part of taxable income. CHANGES TO TAXATION OF FU NOS Penalty for Non-Compliance with Superannuation funds approved under Section 23F and paragraph 23(ja) are exempt from tax on investment income if the fund complies with the "30/20" Government bond investment requirements. From 1st July, 1984 the rate of tax payable on investment income when these requirements are not complied with will reduce from 46% to 30%. Non-Exempt Funds (Section 121 DA) These funds have been used in particular to provide superannuation benefits in excess of those approved by the Commissioner of Taxation as reasonable for tax-exempt funds. Contributions to such funds by employers are not deductable and investment income has been taxed at a rate of 60%.

12 Although there will still be a type of fund subject to a 60% tax rate, virtually all Section 121 DA taxable superannuation funds will become Section 121 DAB funds and the investment income will be taxed at 46% from 1st July, As a deduction has not been allowed for employer contributions to these funds, it would be logical to exempt from tax a part of the benefit equal to these contributions. However the Government has stated this will not be allowed, and the reduction in the tax rate is in part recognition of the heavy tax burden which will be incurred by employers and employees in respect of benefits provided through such funds. Section 79 Funds These funds have been operated by banks, life offices and others to allow employees to supplement benefits from their employers' funds, or provide their own benefits where their employer does not operate a fund for them. These funds have been taxed on investment income in excess of 5% of the cost of assets. These funds become Section 23FB funds under the revised legislation. From 1st July, 1984 they will be exempt from tax on investment income, even though they are not required to comply with the "30/2OU requirements. In addition benefits will only be "locked in" under these funds until age 55 instead of age 60.

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