Sadly, almost every family business in Perth has asked their tax accountant – how is the tax treatment of my unfair dismissal payment treated?
The tax treatment of legal fees paid on unfair dismissal
If your family business incurs legal fees defending an unfair dismissal claim, the legal fees paid are tax deductible. The legal costs incurred are a necessary part of carrying on a Perth business – and if your business activities generate taxable income, the legal fees paid to defend an unfair dismissal claim are also tax deductible.
If your business is registered for GST and you can ordinarily claim GST credits on your ordinary costs, then the GST attached to the legal fees paid in defending an unfair dismissal claim are also tax deductible.
If you have structured an employee share scheme, the concepts become more complex, and you might need specialist advice.
The tax treatment of former employees’ legal fees
Sometimes, the court or the mediator will negotiate an outcome. The outcome will often be out of your control and require you (or your family business) to pay the legal fees incurred by the former employee as part of the final claim.
This payment will often require a family business in Perth to ask their tax accountant – if I pay personal legal fees for a former employee, can I claim a tax deduction for these legal fees? Can I enjoy a GST credit for GST paid on my former employee’s legal fees? Do I need to pay fringe benefits tax on the employee’s legal fees? In other words – is the payment of legal fees for a former employee’s unfair dismissal case an expense fringe benefit?
Are former employees’ legal fees for unfair dismissal entitled to an income tax deduction?
Suppose a court requires you to pay the legal fees of a former employee in pursuing an unfair dismissal case. In that case, it is fair to say that this cost is ordinarily incurred by a business trying to generate income. The general deduction provision of the Tax Act allows you to claim an expense if it is incurred in carrying on a business for producing taxable income. So, legal fees for defending an unfair dismissal claim are tax deductible.
Can a family business enjoy a GST credit on legal fees incurred by a former employee?
To enjoy a GST credit you must have the invoice showing the GST in the name of the family business you are running. However, the GST Act (s111-25) allows you to enjoy a GST for a cost that is an employee reimbursement, even if the invoice is not in the name of the family business employee.
Does the fringe benefits tax apply to reimbursing employees legal fees for unfair dismissal?
Suppose your family business employer pays a cost for an employee, and the employee cost is not tax-deductible to the employee. In that case, that payment will attract fringe benefits tax (unless exempt). Even if you undertake fringe benefits tax planning you might still find that fringe benefits tax applies to an expense payment fringe benefit. Many Perth tax accountants will give you examples of paying for staff holidays or gym memberships that will attract fringe benefits tax because of the operation of the expense payment fringe benefits tax provisions.
However, where a family business is required, through some quasi-government authority, to pay for the legal fees of a former employee, it is worth knowing that the family business owner in Perth is only making the payment because of that authority. The payment is not in respect of the employment of the employee.
The following are reasons why a Perth tax accountant will say there is not a connection between the payment of legal costs and the employment of the employee (so no FBT):
- You are forced to pay legal expenses after the termination of the employee;
- At the time that the costs are incurred, there was no right by the employee to recover those costs, as costs can only be awarded at the discretion of the Court;
- The costs do not form part of the damages from the termination of employment
- The payment is not a result of the employment contract because the court forces the payment (TR 2012/8)
Given the above positions, it is reasonable to say that paying the personal legal expenses incurred by a former employee pursuing the employer will not incur fringe benefits tax.
Will compensation on termination of employment be assessable as income to the employee?
The tax treatment of compensation payments made upon termination of employment hinges on the nature of the compensation. Specifically, it depends on whether it is considered income or capital.
The compensation received as a substitute for another amount will adopt the character of the original amount (FCT v Dixon (1952) 86 CLR 540). So, a compensation payment, even if received as a lump sum, is classified as income if it is a substitute for an item that would typically be considered income.
Determining the characterisation of compensation payments to an employee upon termination involves identifying the underlying amount the employer is obligated to compensate (e.g., annual leave, notice period).
If you are considering unfair dismissal claims it is also worthwhile acknowledging that there are multiple ways of simplifying the right to work checks for your team as part of your HR management.
Common examples
Some common compensation payments made to employees upon termination of their employment include:
- Unpaid wages, annual leave, and long service leave: These payments substitute regular income and are typically assessable as income (Tax Determination TD 93/29; ATO ID 2002/391 and ATO ID 2004/659).
- Payment instead of notice: This payment replaces the income stream that would have been received during the notice period and is generally considered income (Romanin v FCT (2008) 73 ATR 760).
- Wrongful dismissal compensation (e.g., unfair dismissal): Compensation for denying the right to lawful dismissal is considered capital and, therefore, not assessable, regardless of whether it’s based on unpaid salary or lost income (Tax Determination TD 93/29).
- Compensation for restriction of other rights: Amounts received for entering restrictive covenants are typically capital (Margerison v Tyresoles Ltd (1942) 25 TC 59). For instance, payments made for not disclosing confidential information are considered capital, not ordinary income (Paykel v FC of T 94 ATC 4176).
Receiving compensation payments as a lump sum doesn’t automatically classify the amount as ordinary income. If the lump sum includes components that would have been income in subsequent years (following the replacement principle), the entire sum is assessable income in the year received (Re Hannavy and FCT (2001) 47 ATR 1018).
If a lump sum comprises both income and capital components and these components are definitively identifiable, the amount is apportioned accordingly (Tax Determination TD 93/58). Otherwise, if the elements can’t be separated, the entire amount is considered capital (McLaurin v FCT (1961) 104 CLR 381; Allsop v FCT (1965) 113 CLR 341).
Once the character of the compensation payment is established, its tax treatment becomes clearer.
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Tax treatment in the employee’s hands
The development of cloud accounting software for payroll has simplified the calculation and reporting of ETP’s significantly. Suppose a payment to an employee upon termination of their employment qualifies as income in their hands. In that case, it may be assessable to the employee as an “Employment Termination Payment” (ETP) under Division 82 of the Income Tax Assessment Act 1997.
ETPs are subject to concessional taxation, meaning that a portion of the ETP may be tax-free, and the recipient may also receive a tax offset. Payments classified as ETPs, falling below the applicable ‘cap’ (as described below), are typically subject to a maximum tax rate of 30%.
An ETP refers to a payment received by an individual due to the termination of their employment (or another person’s employment). It must be disbursed to the individual within 12 months of termination and cannot be excluded from the definition of an ETP.
Examples of payments that do not qualify as ETPs include:
- Superannuation benefits;
- Unused annual leave or long service leave;
- Deemed dividends;
- The tax-free component of a genuine redundancy payment (as outlined below); and
- Certain capital payments for personal injury or restraint of trade contracts.
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An Employment Termination Payment (ETP) received by an individual during their lifetime is classified as a ‘life benefit termination payment’ and comprises both a tax-free and a taxable component. The tax-free component includes:
- Any portion of the payment attributable to services provided before July 1983.
- Any portion of the payment compensates the employee for termination of employment due to their invalidity.
The remaining portion of the life benefit termination payment is taxable and is included in the individual’s assessable income. The individual may also qualify for a tax offset for the part of the ETP falling below the relevant cap (the ETP cap). This tax offset ensures that the taxable component of the ETP within the cap is taxed at either 15% or 30%, depending on the recipient’s age. Any portion of the ETP exceeding the cap is taxed at the top marginal tax rate. In 2024 the ETP cap is $235,000.
There is also a lifetime ETP cap of $1,615,000.
When considering the tax treatment of ETP’s on an unfair dismissal case it should also be recalled that payroll tax in WA might be calculated on your ETP.
Genuine redundancy payments
When an employee’s termination is a result of their position becoming redundant, any payment they receive upon termination might qualify as a genuine redundancy payment instead of an ETP.
A genuine redundancy payment constitutes the portion of the payment made to an employee by the Perth family business employer due to their position being genuinely redundant. The decision to terminate the employee must solely lie with the employer, distinct from an employee’s choice to resign or retire. To qualify as a genuine redundancy payment, Perth tax accountants will often list the following criteria to be met:
- The employee must be terminated before reaching 65 years of age (or earlier if the termination was predetermined).
- The dismissal and payment were conducted at arm’s length.
- There was no agreement for the employer to rehire the employee post-dismissal.
- A payment cannot be considered a genuine redundancy payment if it is an ETP or a substitute for superannuation benefits.
A genuine redundancy payment comprises both a taxable and a tax-free component. The tax-free amount is determined using a statutory formula based on the employee’s length of service with the employer. Any payment exceeding the tax-free component is taxable income for the individual.
Getting HR right
With the difficulty of understanding the tax treatment of unfair dismissal claims many tax accountants also find this undertaking by the courts uncovers other problems. There are many areas where HR rules might surprise you so getting HR advice from your Perth tax accountant to ensure compliance is correct is always prudent.
Conclusion
At Westcourt we think you should know the cost of a decision before you make it. When dealing with employment and unfair dismissal, it is critical that you deal with a focused firm with national and international connections and proven technical tax excellence. This is where Westcourt is a natural fit – and without upfront quoting policy we take away all the risk of surprise – so why not give us a call?
