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Everything you need to know about taxing retrenchment packages

by , 05 November 2014
You may think your employee tax responsibilities end when you retrench an employee. But you're wrong.

If you retrench employees, you must give them a retrenchment package.

And, like PAYE and fringe benefit tax, you'll have to work out and withhold tax on this amount as well.

Here's how to do this...

 

Here's how to handle the tax on a retrenchment package

 
The tax treatment of a retrenchment package is complex at best. (As a general rule, the taxable portion of a lump sum you give your employee upon retrenchment isn't taxed at the marginal rate. You need to tax it at the average rate for the previous or current year of assessment depending on which one is greater.)
 
Your employee's also entitled to a lifetime exemption of R30 000 on a gratuity you give him upon retrenchment. 
 
Here's an example that explains what all this means.
 
Ms Coomar is 58 years old and has been working for XYZ (Pty) Ltd since 1 September 2009. In August 2013, her employer retrenches her because the company's board of directors decides a general reduction in staff was necessary to cut excess and improve the company's financial position. 
 
The following information is relevant.
Effective date of retrenchment: 31 August 2013
Monthly salary: R10 000
Daily pay rate: R441.11
 
There is no company medical or retirement benefit scheme.
Ms Coomar's average rate of tax for 2013 tax year: 20.09%
 
Annual salary in the past three years of assessment:
2010: R102 885
2011: R108 300
2012: R114 000
 
She was offered the following package:
 
Leave pay: R3 308.33 (R441.11 x 7.5)
Pro rata bonus: R5 000.00 (R10 000 x (6/12))
Retrenchment gratuity: R40 000
 
Here's how XYZ (Pty) Ltd will calculate Ms Coomar's normal tax liability for the 2013 year of assessment.
 
The rating formula is used to determine Ms Coomar's annual tax liability because she received a lump sum benefit under a general reduction of staff as a result of her employer's operational requirements.
 
Here's the formula the company used to work out her tax on the retrenchment package.
 
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Here's the formula Ms Coomar's ex-employer used to determine her annual tax liability a

 
 
Y = the amount to be determined,
A = the amount of normal tax (excluding rebates) calculated at the full rate of tax chargeable for a taxable income equal to the amount represented by the expression 'B + D – (C + L)' in the formula;
B = the taxpayer's taxable income for said year;
C = not applicable;
D = any deductions claimed for retirement annuity contributions;
L = taxable portion of a lump sum. Section 7A(4A) of lump sum subject to the rating formula limited to the lesser of the taxable portion of the lump sum and three times the average annual salary over the previous three years; and
R = the greater of the average tax rate in the current or previous year of assessment, excluding all rebates.
 
Therefore, in Ms Coomar's case, the calculation will look like this:
 
A = Normal tax on R78 308.33 + 0 – (0 + R10 000)
= Normal tax thereon: (R68 308.33 x 18%)
= R12 295.50
B = R78 308 .33 (R60 000 + 3 308.33 + 5 000 + R10 000)
C = 0
D = 0
L = R10 000 (R40 000 – R30 000). Section 7A(4A) lump sum limited to the lesser of the taxable portion of the lump sum and three times the average annual salary over the previous three years i.e. the lesser of R10 000 or R108 395 ((102 885 + 108 300 + 114 000)/3)
R = greater of 20.09% or 18%, which is 20.09%
 
Therefore,
Y = ( 12 295.50 x (78 308.33 – 10 000)) + (10 000 x 20.09%)
78 308.33 + 0 – (0 + 10 000)
Y = (0.18 x 68 308.33) + (2 009)
Y = R14 304.50
 
Ms Coomar will have a tax liability for the 2013 year of assessment as follows:
Normal tax R14 304.50
Less: Primary rebate R 7 200.00
Total tax payable R 7 104.50
 
The tax payable on the lump sum gratuity received is R2 009.
 
There you have it. If you retrench one of your employees, use this formula to correctly work it out. 
 
Don't forget to apply to SARS for a tax directive when you retrench an employee. You need to use the form IRP3(a) when making this application.
 
And check out the Practical Tax Loose Leaf Service for more information on how to handle your employees' taxes.
 


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