When is compensation received upon termination of employment taxable?

What constitutes fair termination?

According to the Labour Act, the fair termination2 of a worker’s employment includes the following:

• Termination due to the worker’s incompetence;
  
• Termination due to the worker’s proven misconduct;
  
• A redundancy under section 65 of the Act; and
  
• Termination due to legal restrictions imposed on the worker prohibiting the worker from performing the work for which they are employed.
  

As stated above, redundancy is considered one of the grounds for fair termination of employment. This implies that all redundancies are, indeed, terminations but not all terminations are redundancies. After redundancy is established, an employee is entitled to receive compensation referred to as redundancy pay.

Redundancy pay is defined by the Labour Act as a payment made to a worker by the employer immediately prior to the closure, arrangement,3 or amalgamation of the company that results in the severance of the legal relationship between the worker and the employer and in the worker becoming unemployed or suffering a reduction in the terms and conditions of their employment.

In Kobi v. Ghana Manganese Co Ltd (2007-2008), Justice Ansah of Ghana’s Supreme Court defined “redundancy” under the prevailing Ghana law as follows:

The collective agreement did not define the terms “termination” and “redundancy” though it made provisions for them. Speaking generally, the two terms have different meanings and connotations; for by this ordinary meaning, to “terminate” is to put an end to, bring to an end; or, to conclude. In a cause or matter affecting employment, it means to sever an employer-employee relationship. A “redundancy” would arise where major changes in mode of production, programmes or activities of a company were likely to result or resulted in reduction of the needed labour force and there was excess labour.

In effect, no redundancy pay would be due a worker whose employment contract with an employer has been terminated where the conditions and procedures for redundancy are not in view.

Further to this argument, in National Labour Commission v. First Atlantic Bank (2020), the Supreme Court provided clarity in its ruling, though it hinted that the terms “redundancy” and “severance” may be used loosely:

[T]he form of compensation for the worker is left in the hands of the employer and the terminated employee or employee’s union to negotiate. The compensation need not necessarily be "redundancy pay." It may take the form of the payment of “redundancy pay” nonetheless. It may also take the form of other measures taken to ensure that the redundant employee is given an alternative employment within the same entity or another. It appears to us that where the employer is unable to find a suitable employment for the employee in the same undertaking or another, the only other means of cushioning the employee against the adverse effects of the termination or redundancy may be the payment of monetary compensation which is variously referred to as "severance pay" or "redundancy pay."

The court also established that the form of compensation (under redundancy) given to the worker must not necessarily be in the form of cash payment but may take into consideration other measures, such as providing alternative employment to the individual.

Explicit exemptions

It is worthy of note that the following categories of workers are not entitled to redundancy pay:

1. Workers engaged under a contract of employment for a specified period of time or for specified work;
2. Workers serving a probation period or a qualifying period of employment of reasonable duration determined in advance; and
3. Workers engaged on a casual4 basis.
   

Tax implications of redundancy payment

Generally, all gains and profits received by employees in respect of their employment from their employers or employers’ associates are taxable. However, payments made to workers declared redundant are not taxable because such payments are specifically exempted from tax in the hands of the recipients. The payments are not received in return for services rendered or even for future services. Any lump sum payment made to an employee as genuine compensation for a loss of position and any similar payment to an employee on the termination of their contract of employment (because of a management decision) is exempt from tax. This means that a lump sum payment made to an employee who resigns of their own volition (and not because of a compulsory layoff or an offer to resign) is generally taxable.

It is instructive to note that, while redundancy pay is tax exempt in the hands of the recipient or beneficiary, to the extent that a particular cessation of the employer-employee legal relationship does not meet the provisions of the Labour Act, the payment will be taxable, no matter how the organization labels it.

It is necessary to evaluate the compensation package received by a worker as it may comprise payments that relate to the employee’s entitlements under the employment contract that may be taxable. For instance, the compensation package may include elements of accrued leave payments and other end-of-service benefits unrelated to the employee’s redundancy.

Conclusion

It is erroneous to assume that all severance packages are exempt from tax due to the empathy that one may feel for those who have lost their employment. A careful scrutiny of the events surrounding the severance as well as the employment contract or severance agreement is necessary to ensure that the correct tax treatment is applied.