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Tax and Retrenchment: A Potential Minefield

Retrenchment can be extremely taxing … in more ways than one!

Being retrenched is a traumatic experience regardless of your place on the corporate totem pole. However, the stakes tend to be higher for more senior employees – not only in terms of the larger sums involved when it comes to separation packages, but also the significant financial loss that can be experienced if all parties concerned don’t get it right.

However, any employee receiving the news that they are to be retrenched puts them at an immediate disadvantage. This is because the employer has spent a great deal of time considering their options, making their decision, and putting together their proposals—then presenting all of this to the hapless employee almost as a fait accompli, often without any warning prior to being summoned to a meeting.

Employees facing this situation invariably feel overwhelmed—not only by the shock of finding out that their employment is about to be terminated, but also through having to face their immediate manager, someone from HR, and (possibly) their employer’s legal representative, all sitting on the opposite side of the table each with a sheaf of documents in front of them.

With their head swimming with shock, emotion, what appears to be some large monetary values, and a desire to get this painful episode over with as quickly as possible, they end up signing the agreement. However, once the ink has dried on the document, it becomes binding—and what follows may well be in the best interest of the employer, but not so favourable for the employee.

Given the magnitude of the consequences of retrenchment, particularly for senior employees, it is advisable to consult one’s tax consultant, financial planner, and a legal professional who specialises in labour matters before agreeing to sign anything. Requesting time to digest the news and consult with the relevant advisors is not unreasonable, given that the employer has probably spent months putting all of this together, no doubt with the assistance of some rather expensive professional heavyweights!

This article is written from my perspective as a tax professional, based on a real-life situation faced by one of my clients—one which would have probably had a far happier outcome had such client contacted me two years ago when their employer first proposed a possible retrenchment.

Accordingly, it deals with the following tax issues that need to be dealt with prior to signing the retrenchment agreement:

  1. Considering the employee’s existing situation at the time that retrenchment is proposed, which includes looking at the structure of their current investment portfolio as well as their future financial plans (both of which would have originally been based on them enjoying continued employment); and
  2. Examining how the retrenchment proposal impacts and disrupts their current situation, and the necessary tax planning that needs to take place to cater for what is likely to be a significantly changed financial plan.

Please note that the article does not take into account any changes that have been brought about by the introduction of the new two-pot system.

While the new system will undoubtedly have an impact on how one deals with retirement benefits upon retrenchment in years to come, at this stage the bulk of one’s retirement funds will fall within the ‘vested’ pot (save for an initial amount of 10% of the retirement pot, capped at R30 000, which can be transferred into the ‘savings’ pot).

At this early stage, the considerations outlined below are likely to remain largely unchanged for some time, especially for senior executive employees at (or fairly close to) retirement age.

The tax and investment profile of a typical senior employee

Employees in senior positions tend to have remuneration packages that are not only greater than those of the average employee, but also tend to be more complex. In addition to common forms of remuneration structuring such as a car allowance, medical scheme membership, and retirement fund contributions, it is not unusual for the packages of executive-level employees to include incentive elements such as share options, deferred compensation schemes, access to preferential finance facilities, and other perks.

The level of remuneration enjoyed by senior employees often puts them in the higher tax brackets, providing a significant incentive to ensure that such packages are structured as tax-efficiently as possible within the scope of applicable tax legislation.

Furthermore, the higher income levels that go with senior appointments provide a variety of investment opportunities that can often be complex in their structure and management. In addition to ‘normal’ investments such as bank deposits, unit trust investments, and retirement funds, the portfolios of wealthier individuals often include rental properties, Tax Free Savings Accounts, share portfolios, Section 12J investments, tank containers, and direct offshore investments.

Each of these investment vehicles has their own particular tax treatment, and the astute individual would have ideally considered the tax efficiency thereof not only in terms of each individual investments, but also in the context of their overall investment portfolio. This applies not only to current taxes (including income tax and Capital Gains Tax), but also longer-term tax events such as donations tax and estate taxes.

Finally, depending on the composition of the investment portfolio, such an individual is likely to be a provisional taxpayer. While this status does provide certain tax planning opportunities, it also comes with its own set of complexities.

How retrenchment disrupts existing tax planning structures

A retrenchment package tends to have two consequences that operate at odds with each other.  On the one hand, the lump sum settlement may bring about a substantial increase to one’s immediate net worth, particularly for a senior employee with long service. On the other hand, the act of retrenchment terminates a vital income stream, being the remuneration and other benefits that the employee currently enjoys.

Both of these consequences are likely to significantly impact any existing tax planning. Consider the following:

The likelihood of future employability

While stories abound of the young hotshot who flies up the corporate ladder as though they have a jet pack tethered to their careers, most senior employees (particularly those at board level) tend to be older. Most larger companies are led by seasoned well-qualified executives who have honed their experience over many years, often with a number of organisations and sometimes even in different industries.

Once a senior employee has reached the age of 55, employers contemplating retrenchment have the option of structuring the retrenchment as an early retirement. While the attractiveness of this option for the employer may depend on whether they have contractual obligations for post-retirement benefits, an unscrupulous employer could make this appear to be a more attractive option for the employee while surreptitiously attempting to avoid statutory retrenchment pay-outs—which, for senior employees with long service, could be quite substantial.

However, for the older employee, finding comparable employment elsewhere could be extremely difficult.  Corporate appointments at board level for those who have been retrenched from a similar position tend to be rare. While such employees may end up furthering their careers as non-executive directors, the remuneration on offer is normally significantly less than that paid to senior executives.

Accessing retirement benefits earlier than planned

The current tax structure for retirement benefits is based on whether the benefit is a pension, provident, or retirement annuity fund. The tax rates applicable also depend on whether the retirement benefits are accessed before or after the member has reached age 55 (or is retiring due to ill-health).

• At retirement:

For pension funds, the member may receive a lump sum of up to one-third of the total fund, which is taxed at preferential rates. The remaining two-thirds must be used to purchase an annuity, the proceeds of which are taxable as normal income as and when the payments are received.

For provident funds, the member usually receives their total fund as a lump sum. This is also taxed at the same preferential rates as for pension funds. The member has the option of investing their lump sum into something that provides an income, but this is not limited to an annuity—in fact, any investment ranging from bank deposits, to investment properties, to a dividend-paying share portfolio (or a combination of these) may be considered.

While retirement annuity funds are treated the same way as pension funds when one ‘retires’ from the fund, there is no causal link (apart from the possible need for additional income) between the retrenchment event and retirement from the fund, i.e. one can ‘retire’ from a retirement annuity any time from age 55.

This is different to the case with pension and provident funds, where fund membership is often conditional on the existence of an employment relationship. The ex-employee’s options are thus limited to withdrawing / retiring from the fund, making their fund benefit ‘paid-up’, or transferring it to a preservation fund.

• Upon withdrawal:

In the case of pension and provident funds, the member has the option of transferring their total fund to a pension or provident preservation fund (where applicable) without any tax penalty. If the member chooses to withdraw from the fund and receive the proceeds as a lump sum, such proceeds are taxed at fairly punitive rates when compared to the rates applicable upon retirement from such fund.

Access to retirement funds before age 55 is prohibited unless the member is retiring due to ill-health or is emigrating. In the latter case, there is a waiting period of three years before one can repatriate their retirement funds to their new country.

However, understanding the above tax consequences does not necessarily mean that these can be avoided. For instance, the tax tables for both withdrawal and retirement from a retirement fund are based on lifetime limits.

For example, suppose that you changed jobs five years ago and withdrew your lump sum of R600,000.  Assuming that the 2024/25 tax rates were applicable, your tax bill on the withdrawal would have been R103,050.

Now suppose that you elected to receive your lump sum from your current fund as a result of having been retrenched, and let’s say that to keep the sums simple, your fund value also happens to be R600,000. You would assume that your tax bill thereon is still R103,050—same as last time, right? However, the tax calculation would actually be based on the sum of the two withdrawals (i.e. R1.2 million), less the tax deducted from the first withdrawal. The tax on the second withdrawal is thus a whopping R160,200!

It has been my experience that senior employees tend to preserve their retirement benefits, which is a sensible thing to do. However, what happens when such person is now retrenched?

Since any lump sum termination benefit is treated the same as a retirement lump sum for tax purposes, the good news is that the preferential tax rates are applied to the termination benefit. The bad news is that the termination benefit is taken into account when eventually claiming the lump sum from their retirement funds—this results in higher tax rates being applied to the retirement lump sum than what would have been the case had the termination lump sum not been received.

While it could be argued that the termination lump sum represented a ‘windfall’ that had been taxed at preferential rates, tell that to the former senior employee who has potentially lost ten years (or more) of future earnings commensurate with the position from which they had been retrenched. The overall financial loss is likely to far exceed the value of the termination benefit.

The impact on other investments

The possibility that the retrenched senior employee may end up not being able to find further employment at a similar level of seniority and remuneration—a scenario that becomes increasingly likely the older they were when retrenched—may result in having to move from the accumulation phase of their investment strategy to the withdrawal phase at a far earlier stage than originally planned. This has the following potential tax implications:

  • Drawdowns on preservation funds may need to begin sooner than anticipated. Not only does this mean that the future growth (tax-free within the retirement fund structure) is foregone, but income tax will also need to be paid on the amounts drawn down.
  • Ongoing contributions to retirement annuity funds may need to be curtailed. Such contributions are not only impacted by affordability, but with lower taxable income post-retrenchment, the amount available as a deduction (being limited to 27.5% of taxable income) is also reduced.
  • The tax benefit of Tax-Free Savings Accounts (TFSA) could be greatly reduced. Under current (2024/25) rules, individuals may contribute R36,000 per annum, subject to a lifetime limit of R500,000. If contributions are curtailed or reduced to below the annual limit, one cannot ‘catch up’ in future years. Furthermore, if there is a need to withdraw funds from a TFSA, these funds cannot be replaced if the lifetime limit will be exceeded as a result.
  • Tax-structured investment vehicles are often locked-in for a period. Most tax-efficient investments—including endowment policies, structured investments offered by fund managers, and Section 12J investments—have a lock-in period of five years in order to enjoy the beneficial tax treatment.

If the retrenched employee is forced to access these funds prior to the expiry of the five-year period, they will either be prohibited from doing so or will incur a significant investment penalty—not to mention the tax penalties that may be applicable due to early withdrawal.

One can clearly see that the impact of retrenchment is particularly severe on senior employees from a tax point of view—and that’s assuming the best-case scenario where all concerned are negotiating in good faith. It is therefore critical that the tax practitioner is engaged right from the very beginning of the process to ensure that all of the tax bases are covered.

It is also essential that the tax practitioner works in tandem with other members of the client’s team.  The importance of the financial planner’s role is paramount, given that this is a significant, traumatic, and financially life-changing event that is taking place. The labour lawyer has a vital role to play as well in ensuring that the client is treated with the utmost fairness by their employer throughout the process, and that the best-possible settlement can be obtained.

WRITTEN BY STEVEN JONES

Steven Jones is a registered SARS tax practitioner.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein.  Our material is for informational purposes.

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