Perhaps the following is a familiar scenario: you are a high net-worth individual, well-established in your career as a Managing Director in your company. You are contemplating early retirement. Your company will be paying you a “golden handshake”, and you will be taking a lump sum benefit from the company pension fund, of which you have been a member through your company for many years.
The South African Revenue Service (SARS) distinguishes between the sources of a lump sum in an employee's hands when it comes to their taxation. A lump sum paid on retrenchment or early retirement could potentially be paid directly by an employer to an employee, or it could be paid out by a retirement fund (pension, provident or retirement annuity), on the occasion of that employee's cessation as a member of that fund.
A lump sum paid by a retirement fund duly falls into an individual's gross income for the year. But if that individual ceases to be a member on account of his or her death or retirement (the latter being at the appropriate age as defined in terms of the rules of the particular pension fund) the first R315 000 of such amount (cumulatively taking into account all such amounts that may previously have been received by the individual) is tax-free. A sliding scale of tax is applied up to R945 000 (inclusive of the first R315 000 tax-free), whereafter the balance of any lump sum would be taxable at the maximum rate of 36%.
With effect from 1 March 2009, this R300 000 tax-free exemption (R315 000 with effect from 1 March 2011) was extended to apply to qualifying lump sums paid to persons in consequence of their withdrawal from membership of a retirement fund, under the appropriate qualifying conditions, set out below.
If the fund pays a withdrawal benefit to an employee in consequence of the termination or loss of employment due to his employer having ceased to carry on trade, or if the employee has become redundant as a consequence of the employer effecting a general reduction in staff, or, a reduction in staff of a particular class, then the benefit will be taxed as if the employee had retired or died, i.e. it is treated as a “retirement fund lump sum benefit”, as defined.
A lump sum paid by a retirement fund to a departing member in consequence of the termination or loss of employment, however, does not qualify as a retirement fund lump sum benefit if it is paid to an individual who held, at any time, more than 5% of the equity shares of his employer-company.
This means that if you ever held more than f5% of the shares in your company, and despite being paid in respect of your retrenchment, the withdrawal amount paid out by your pension fund before your official retirement date in terms of the fund's rules, would not qualify as a retirement fund lump sum benefit, as defined. Thus, the first R315 000 would not be tax free. It would not qualify as a retirement benefit because it would have been paid too early.
Instead, it would be treated for tax purposes as an ordinary withdrawal benefit in your hands, of which only the first R22 500 would be tax free (provided that the R22 500 has not been set off any previous lump sum withdrawal benefit from any pension fund from which you may have withdrawn in the past).
In this scenario, you would be best advised to wait until your official retirement date as set out in terms of the fund rules before taking your withdrawal benefit. Should you exercise such patience, then the lump sum would be treated as a retirement fund lump sum benefit, irrespective of your having been a shareholder, and thus the first R315 000 would be treated as tax-free (assuming that you had not previously accessed this exemption).
A lump sum paid directly by the employer to an employee who is either retiring or being retrenched also falls into the individual's gross income for the year. The tax concessions have been different from those available to retirement fund lump sums for such amounts up until 28 February 2011. Instead of the first R315 000 potentially being tax-free, a once-in-a-lifetime R30 000 exemption has been available to the taxpayer in respect of appropriately qualifying lump sums. The balance was then taxed at an average tax rate determined in terms of a formula (“the rating formula”).
As of 1 March 2011, however, the R30 000 exemption falls away, and a new definition, “severance benefits”, enters the tax arena. A severance benefit is a lump sum paid by one's employer in respect of one of the following events:
Returning to our scenario, if you accept a voluntary retrenchment package from your employer before the age of 55, the good news is that this will qualify as a “severance benefit”, and thus, taking into account any other similar lump sums you may have received in the past, the first R315 000 of the lump sum will be tax-free.
Of course, you only receive the R315 000 exemption once in your life. Let's assume that you accept a retrenchment package from your employer before the age of 55 and you are in the fortunate position of also being paid out a lump sum withdrawal benefit from your retirement fund as a result of your retrenchment. Effectively, in working out your tax liability, you would add the two lump sums together and set off the exemption available to you, i.e. the full R315 000, provided that you had not previously used any of this exemption.
As mentioned above, if you at any stage held more than 5% of the shares in your employer-company, a lump sum benefit paid on your retrenchment by your employer would not qualify for the R315 000 tax-free exemption. You would then be advised not to accept a retrenchment package, but rather to wait until you are 55 years of age. A lump sum paid to you by your employer after 55 years would then qualify as a severance benefit on the basis of your age.
A severance benefit may also include a lump sum paid by the employer in consequence of an employee's death, which will be deemed to have been paid out immediately prior to the death.
A sliding scale of tax is applicable to severance benefits with effect from 1 March 2011, up to a maximum rate of 36%, as indicated above. This is in terms of the same tax table as retirement fund lump sum benefits have been taxed since 1 March 2009.
Finally, a word on the “rating formula”. This refers to a formula that was applied to lump sums paid by the employer in order to calculate the tax liability on such amounts. Rating allowed for a less onerous rate of tax to be applied to lump sums, provided that they qualified in terms of the legislation. Rating is falling away. The taxation of employer-paid lump sums that qualify as “severance benefits” will then be taxed as set out above instead of being subject to rating.
In summary, all retirement and severance lump sums will be taxed on the sliding scale with the first R315 000 tax-free, except if you ever held more than 5% of your employer's shares, in which case, best you wait ‘til you are 55. asa
Susan McCready CA(SA), H.Dip Tax, is Senior Manager: International Tax Services at KPMG Services (Proprietary) Limited.