Understanding the tax on your severance package

Many companies are considering or are already in the process of retrenching workers due to the economic woes of the country that is being exacerbated by the imposed lockdown to curb the spread of the Covid-19 disease.

A critical part of retrenchment discussions should focus on the tax consequences on the final payments, say Darren Britz, attorney, and Taritha Oosthuizen, remuneration specialist at Remuneration Consultants.

Getting it wrong, they point out, can have severe financial implications for employees.

The Income Tax Act allows for a far more favourable tax treatment on retirement, death or severance benefits. The first R500,000 severance benefit is tax free and the amount above R500,000 up to R700,000 is taxed at 18%. Tax of 18% is charged on income up to R250,900. Only R25,000 is tax free if an employee makes early withdrawals from retirement funds.

The Labour Law allows for a minimum payment of one week per completed year of service. In many instance companies are prepared to sweeten the deal if enough people take voluntary packages, thus preventing a formal involuntary process.

It is advisable to have the final agreement in writing. It does not have to be a formal legal document. The language during the discussions becomes very important, said Britz.

“When you talk about the retrenchment amount, you have to ask about the tax costs. Employees should ask for a very basic calculation to see what the impact of the tax liability will be.”

Previous severance payments

Employees are strongly advised to remind the current employer of any previous severance payments or retirement lump sums that was paid to them. This means that the full R500,000 tax exempt amount is no longer available, Oosthuizen said.

Many employees tend to forget that the R500,000 tax free amount is over their lifetime and not for every retrenchment event.

“Your employer’s tax calculation will be wrong if he is not made aware of the amounts received previously. If the employer knows that your tax bill may be more because the exempt amount has been depleted or eaten into, he may offer a bigger package to put you in a better position.”

Tax directives

Once the discussion is complete and the employer and employee have reached an agreement, the employer must apply for a tax directive from the South African Revenue Service (SARS) to set out the tax obligation in terms of the severance payment, said Oosthuizen.

The employer will deduct the tax as indicated in the directive and pay it to SARS before the retrenchment package is paid to the employee. In many instances employees are left aghast because they received less than what they anticipated – mostly because they did not fully understand the tax consequences.

“It has also happened that employers pay a severance amount but neglect to apply for a tax directive. The employee only becomes aware of the tax liability when he files his tax return months after receiving the amount and SARS taxes it as normal income,” the remuneration specialist said.

Tax debt

Equally devastating is the realisation that the employee had outstanding tax debt which will also be deducted from the agreed amount. Debt may arise when employees neglect to file returns when they are obliged to do so, said Britz.

“Once the directive has been issued and the payment made to the retrenched employee their only remedy is to lodge an objection when there is a dispute.”

Only the employer can request the cancellation of a directive when there are errors. One such error – that can cost a taxpayer dearly – is when the “wrong box” on the directive is ticked, he said.

“The directive provides for severance payments, but employers have inadvertently ticked “other”, which means the amount will be taxed at normal income tax rates and not the beneficial rate for severance benefits,” said Britz.

Talk first, pay later

Ideally the employer should have another discussion with the employee once the tax directive has been issued and before the final payment is made, Britz said.

“That would be far more beneficial because the employer will be able to cancel a disputed directive and reapply with the correct information. It is a simple and easy process, but should be done before the payment is made to the retrenched employee.”

Employees are not obliged to accept a voluntary retrenchment offer if the payment terms are not acceptable,” Oosthuizen said.

“However, it would be prudent to only reject an offer if the employee is fairly certain he will survive a formal retrenchment process, or if the offer is equal or lower than what he would get with an involuntary retrenchment process where he may only receive the statutory minimum.

“While retrenchment is an extremely sensitive matter, a high level of discernment, accuracy and professionalism will go a long way in ensuring that the best tax outcome is achieved,” Oosthuizen said.

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Understanding the tax on your severance package