Is Termination Compensation Taxable in Malaysia?

Is compensation for loss of employment taxable?

Yes. Section 13(1)(e) of the Income Tax Act 1967 treats as employment income any amount paid to an employee, before or after the employment ends, as compensation for loss of the employment. It is taxed together with the employee’s other income for the year.

The relief comes from paragraph 15 of Schedule 6, which exempts:

• the whole payment, where the Director General is satisfied that it was made on account of loss of employment due to ill health; and
• in other cases, RM10,000 for each completed year of service with the same employer or with companies in the same group.

For the 2020 and 2021 years of assessment, the limit was temporarily raised to RM20,000 for each completed year. It is now RM10,000. The exemption does not apply to a payment made by a controlled company, broadly one controlled by five or fewer persons, to a director who was not a full-time service director.

For example, an employee with eight completed years of service who receives RM120,000 as compensation is exempt on RM80,000 and taxed on the remaining RM40,000. Only completed years count, so seven years and eleven months of service counts as seven.

Which payments count as compensation for loss of employment?

What matters is what the payment is for, not what the parties call it. Payments made because the job has been lost, such as retrenchment or termination benefits and ex gratia payments on termination, are generally compensation for loss of employment. Payments for the employment itself are not. These are taxed as ordinary employment income:

• salary and allowances up to the last day of employment;
• payment for unused annual leave;
• bonuses and commissions earned;
• gratuity on completing a contract or on retirement, which has its own partial exemption of RM1,000 for each completed year of service, and full exemption in some retirement situations.

Describing a salary payment as compensation will not change how it is taxed, and LHDN may look behind the description in an audit.

How are retrenchment benefits and separation schemes taxed?

Statutory termination benefits under the Employment (Termination and Lay-Off Benefits) Regulations 1980, and any larger contractual or negotiated retrenchment package, are generally compensation for loss of employment, and the RM10,000 per year exemption applies to the total.

Payments under a voluntary separation scheme or a mutual separation scheme are usually treated in the same way, because they are paid for giving up the employment. The terms of the scheme and the way the payment is calculated still matter, so employees should ask how the employer has classified each part of the package.

Whether a retrenchment was lawful is a separate question from how the payment is taxed. A retrenched employee may still claim unfair dismissal if the redundancy was not genuine or the selection was unfair. See Industrial Court Decision on Redundancy and Unfair Dismissal.

How are Industrial Court awards taxed?

An award for unfair dismissal usually has two parts. Backwages, capped at 24 months’ salary for confirmed employees and 12 months for probationers under the Second Schedule to the Industrial Relations Act 1967, reflect the salary the employee would have earned. Compensation in lieu of reinstatement, commonly one month’s salary for each completed year of service, compensates for the loss of the job itself.

Because tax follows the nature of the payment, backwages, which replace lost salary, are generally taxed as employment income, while compensation in lieu of reinstatement falls within section 13(1)(e) and can benefit from the RM10,000 per year exemption. Employers usually deduct tax from the taxable portion of an award, and the employee then declares the amounts in his or her tax return.

Awards often order payment “less statutory deductions, if any”. In Malaysia Building Society Berhad v Mahkamah Perusahaan Malaysia & Zainol Rashid bin Norddin (Application for Judicial Review No. WA-25-371-11/2021), the High Court held that this phrase refers to deductions taken out of the award sum. It does not oblige the employer to pay tax or EPF contributions on top of the award, and EPF contributions are payable only if the award expressly orders them.

What should a settlement agreement say about tax?

Many termination disputes settle before or during Industrial Court proceedings. The settlement agreement should deal with tax expressly:

• state whether the sum is gross or net of tax and other deductions;
• break the sum into its parts, such as outstanding salary, leave pay and compensation for loss of employment;
• make sure the description of each part matches what it is really paid for;
• say who bears any tax found to be payable later;
• record the employee’s completed years of service, which drives the exemption.

A clear breakdown protects both sides. The employee knows what will actually be received, and the employer can show LHDN how the payment was treated. See What Is Unfair Dismissal in Malaysia? for the underlying claim.

Are EPF contributions payable on termination payments?

EPF contributions are payable on wages. The definition of wages in the Employees Provident Fund Act 1991 excludes gratuity, retirement benefits and retrenchment, lay-off or termination benefits, so contributions are generally not payable on them. EPF also lists payment in lieu of notice of termination among payments that are not subject to contributions. Salary paid on exit, such as the final month’s salary, remains subject to contributions in the usual way.

How does the employee claim the exemption?

The employer reports the payment in the employee’s Form EA for the year. When filing the income tax return, the employee declares the compensation and claims the exemption for the completed years of service. Keep the termination letter, the settlement agreement or award, and a document showing the start date of employment, in case LHDN asks how the exemption was worked out.

If more tax was deducted than was due, the excess is set off when the return is assessed and any balance is refunded. See also Constructive Dismissal in Malaysia: Think Twice Before You Walk Away.