TITLE: Compensation for Loss of Employment

DATE: 27/01/2012

This Ruling serves to explain the characterisation of lump sum payments received by employees upon the termination of their employment as compensation for loss of employment and the relevant tax treatment pertaining to the compensation for loss of employment. The relevant provisions of the Income Tax Act, 1967 (the Act) related to this Rulings are Sections 7, 13, subsection 83(3) and paragraphs 15 of Schedule 6. This ruling shall take effect from year of assessment 2012 and onwards.

(i) What Constitute Lump Sum Payment on Termination of Employment and Payment for Compensation for Loss of Employment
 
LUMP SUM PAYMENT ON TERMINATION OF EMPLOYMENT PAYMENT FOR COMPENSATION FOR LOSS OF EMPLOYMENT
Amount paid on the termination of an employment may comprise:
a. payment attributable to the loss of employment such as redundancy (compensation);
b. payment attributable to the past services of the employee (gratuity).
Compensation for loss of employment1 is included in Paragraph 13(1)(e) of the Act as gross income from an employment. It may be made:
a. at the discretion of employer where the employment is terminated prematurely which may occur due to a reduction or ceasing of a particular kind of work or possibly, a complete closure of a business/ department or a takeover, merger or re-organisation of a business;
b. under a court order in proceedings for wrongly dismissal or otherwise for breach of contract of employment or a settlement between the parties to such proceedings; or
c. by way of compensation for the extinguishment of any right, the infringement of which will be actionable.
  Employees can seek redress of wrongful dismissal or termination breaches of the employment contract by the employer by making a complaint or claim to the Department of Industrial Relations Malaysia, Industrial Court, Civil Courts or Labour Court. Where the courts find that the dismissal was without cause or excuse, the two remedies will be reinstatement of the dismissed employee and/or monetary compensation for the wrongfully dismissed employee. Thus, the monetary award by the court has to be analysed to ascertain the appropriate tax treatment on the recipient.
(ii) Determination of Elements of Compensation and Gratuity
  For purposes of tax exemption, the characteristics and nature of termination payments prevail over form and labeling of such payments. The method of apportionment between compensation and gratuity depends on circumstances of the case.

In general, consideration is given to the employer’s normal practice (such as the company’s policy / practice) in granting gratuities to employees leaving his service and the rate or amount of gratuities normally granted.
 
COMPENSATION GRATUITY
If the lump sum payment is received due to the premature termination of an employment which has the prospect of continuing up to the retirement age, such amount would tantamount to compensation for loss of employment. Where a contract of employment is for a specific number of years and the employment ends at the specified time or the retirement age, any lump sum paid to the employee should be treated as gratuity.

This is because the employment has ceased in view that the full term of the contract has expired or the cessation of the employment is at the retirement age.
(iii) Tax Treatment of Compensation for Loss of Employment
  A payment (other than a payment by a controlled company to a director of the company who is not a full-time service director2) made by an employer to an employee of his as compensation for loss of employment or in consideration of any covenant entered into by the employee, restricting his right to take up other employment of the same kind is given full or partial exemption on the following basis pursuant to paragraph 15 of Schedule 6 of the Act:
 
a. Provided the Director General (DG) is satisfied that the payment is made on account of loss of employment due to ill health (the health condition has to be certified in writing by a Medical Board of which has to be forwarded to DG), the compensation is fully exempted; or
b. In the case of a payment made in connection with a period of employment with the same employer or with companies in a group, an exemption up to RM10,000 is given for each completed year of service, with effect from 1 July 2008.
  Period of employment with the same employer includes:
 
a. A period of employment in a business where the employer has changed but the management and control of the business remains substantially with the same person or persons.
b. If an employment is with companies in the same group, any period of employment with the various employers within the same group of companies is taken to be a period of employment with the same employer. Pursuant to subsection 2(4)of the Act, companies are in the same group if:
 
1. two or more companies are related within the meaning of Section 6 of the Companies Act 1965;
2. a company is so related to another company which is itself so related to a third company;
3. the same persons hold more than fifty percent (50%) of the shares in each of two or more companies; or
4. each of two or more companies is so related to at least one of two or more companies to which item (3) applies.
(iv) Separation Scheme
  Effective year of assessment 2007, any payment received by an employee from an employer for an early termination of an employment contract under a separation scheme, will be granted tax exemption pursuant to subparagraph 15(3) of Schedule 6 of the Act. Subparagraph 15(3) of Schedule 6 will apply if such a scheme from which payment had been made does not expressly or impliedly provide for the employee to be reemployed under any other scheme of employment by the same or any other employer.

Where the separation scheme offers the employees reemployment with the same employer or any other employer, the payment under the scheme does not qualify for an exemption.
Note 1 Compensation for loss of employment include (i) salary or wages in lieu of notice; (ii) compensation for breach of a contract of service; (iii) payments to obtain release from a contingent liability (employer’s obligation) under a contract of service; (iv) ex-gratia or contractual payments such as redundancy, severance payment made to employees who have become redundant for reason beyond their control; (v) payment in consideration of a covenant, arrangement or similar agreement restricting the activities of an employee in respect of engaging in an employment of a similar kind after termination of his employment.
  2 Service director in relation to a company refers to a director who is employed in the service of the company in a managerial or technical capacity, and is not, either on his own or with any associate or associates, the beneficial owner of (or able directly or through the medium of other companies or by any other indirect means to control) more than 5% of the ordinary share capital of the company.

To view full text and more case studies in distinguishing between compensation for loss of employment and gratuity and also separation scheme contained in PR No. 1/2012, click HERE.