ATO draft ruling hits dual-capacity employees facing redundancy – SME sector most affected
Australia: As the threat of further redundancies loom, chartered accountants and business advisory firm, PKF, warn company directors that they can no longer assume that potential redundancy payments to themselves will be tax-free. Currently, any employee whose employment is terminated due to genuine redundancy can receive a tax-free redundancy payout (up to a certain limit) but a new draft ruling from the Australian Taxation Office (ATO) seeks to restrict employees who are also directors of companies from qualifying for tax-free payments.
Lance Cunningham, Director of Taxation for PKF Australia Limited, said the main determinant for receiving a tax-free payment is that the redundancy is genuine and involuntary. Because this clause has been abused in the past, the ATO is responding by significantly tightening the guidelines. Of particular concern is that the current draft ruling determines that employees in a director role are highly unlikely to experience genuine involuntary redundancies given the likelihood that they would have been involved in business decisions to make their position redundant.
"If this ruling is finalised without amendment, it would restrict or even remove the availability of these tax concessions in situations involving dual capacity employees (company directors who are also employees) who have experienced involuntary redundancies," said Mr Cunningham.
The draft ATO ruling states that a dual capacity employee will only qualify for the tax-free redundancy payment if they do not consent to or approve the decision to terminate their own employment. The ruling does allow one exception to this rule where the termination decision is dictated by legal or economic factors, leaving the employer’s decision-makers with no real or practical choice other than to terminate their own employment, in which case a dual capacity employee may qualify for a tax-free redundancy.
"However, the requirement in the draft ruling that the closure of a business or business division must in effect be forced upon the directors does not take account of business reality. The reality is businesses often resort to redundancy before the directors are forced to do so by external forces as part of a survival strategy. Particularly given the current economic conditions and outlook, there are many external factors which may mean that the wise business decision will be to restructure and close down a division of a business before they are forced to, unfortunately putting some directors out of their day-to-day role. However, this situation is not clearly addressed by the ATO draft ruling.
Mr Cunningham said that PKF has assisted in preparing a submission to the ATO on the draft ruling with recommendations to make the ruling more clear and fair to all businesses before being ratified. They provided the following case study which describes a potentially common SME scenario and their recommended view:
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Example of a genuine redundancy of an SME dual capacity employee
Mr and Mrs Banks established Front Line Pharmaceuticals Pty Ltd (Front Line) thirteen years ago. Mr and Mrs Banks are and have been the only directors of the company for the past fifteen years. Mrs Banks is also employed by Front Line as the company accountant. She manages four staff members in the accounting and administration division.
Over the years, the business has grown substantially. Its annual sales have reached $20m. It employs over 50 sales representatives nationwide. However, many strong competitors have emerged in the past few years and slowly taken away Front Line’s market share.
As a result of fierce competition, sales results and profit margins have declined significantly and net profit is trailing behind competitors. Mr and Mrs Banks realise that if Front Line is to survive in the pharmaceutical sales business, it must reassess its business structure and achieve major efficiencies. For this purpose, they decide to engage a consultant to find an appropriate business solution.
The consultant identified, among other things, that significant benefits can be obtained by outsourcing accounting and administration functions. These benefits include significant cost savings, timely management reports, less office space and equipment, eliminating problems caused by high staff turnover, and freeing up resources in the IT department for implementing and maintaining systems to support Front Line’s core business activities in sales, inventory and distribution.
After careful consideration, Mr and Mrs Banks decide to implement most of the recommendations made by the consultant including outsourcing of the accounting and administration functions. In a directors’ meeting both Mr and Mrs Banks resolve that all positions in the accounting and administration division be made redundant. As a result, all five staff members in the division are made redundant including Mrs Banks in the capacity of the company accountant. No arrangement has been made to reemploy any of these employees (Mrs Banks remains a director of Front Line).
Mrs Banks receives an arm’s length payment in accordance with the terms and conditions applicable to all employees that are made redundant at the same time. Although Mrs Banks remains a director of Front Line, her remuneration as a director is at market value and will not be affected by her redundancy.
It is clear in this case that if Front Line wishes to remain an economically viable business it has no choice but to restructure its business. The directors, in discharging their fiduciary duties, have made a conscionable decision to outsource the accounting and administrative functions. The redundancy is a result of such a critical business decision and, therefore, is a genuine redundancy.
In this situation, all evidence indicates that Mrs Banks’ redundancy payment is a genuine redundancy payment: she consents to her own termination of employment due to economic compulsion; her redundancy payment is at arm’s length; she is not reemployed by Front Line after the termination; and her director’s fee is not inflated after her position as the company accountant is terminated. |
Mr Cunningham concluded that SME’s in particular were likely to consider redundancy in tough times. "They are not always as well equipped to manage a downturn as their larger counterparts, but if the ATO ruling is finalised as is, these businesses will be penalised and dual capacity employees will have more hoops to go through to access concessional treatment on genuine redundancy payments," he said.