Edited version of your private ruling

Authorisation Number: 1012568577317

Ruling

Subject: Special Benefit - medical discharge

Question

Will the payment of a special benefit to an employee in a middle management position, where the employment has been terminated on medical grounds, contain a tax-free component consisting of an invalidity segment determined under section 82-150 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, provided all the conditions under section 82-150 of the ITAA are met.

This ruling applies for the following period:

For the year ending 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

1. Currently when an employee is promoted to a middle management position, they become employed under a fixed term appointment. In recognition for this reduced certainty of employment, employees are entitled to the payment of a special benefit (SB), equal to a percentage of total salary earnings for each completed term appointment. This SB accrues after each completed term and is paid out either when the employee is terminated, medically discharged or if they are promoted to a senior executive position.

2. A SB payment ceases if the employee is promoted to a senior executive position. However on appointment as a senior executive position, these employees are given a one-off opportunity to cash in their accrued SB balance. If the employees choose not to cash in the SB, the value of the SB is preserved and paid out at a later stage when the employee's employment is terminated.

3. A private ruling that issued to the employer during the 2011-12 income year advised that if an employee decided to cash in the SB when they are in a senior executive position the payment was not an employment termination payment and was taxed at the employee's marginal rates.

4. Previous advice from the ATO to the employer several years ago advised that the payment of the SB was treated as an employment termination payment if it was paid on the termination of the employee.

5. The employer wish to seek advice on the taxation of a payment of a SB to an employee who is medically discharged.

6. You advised the relevant section in the current award governing the payment of the SB to employees in a middle management position.

7. You advised the relevant section in the Act and Regulation governing the medical retirement of an employee in a middle management position.

8. The definition for death and disability payments in the relevant section of the Act states that "death and disability payments" means payments (whether periodic or lump sum) to or in respect of an employee who dies or who becomes permanently or temporarily incapacitated for work as a result of being injured at work, or as a result of being injured while employed as an employee and includes payments to or in respect of an employee by way of the top-up of workers compensation payments.

9. A specific section of the Regulation governing the medical retirement of an employee in a middle management position provides a scale to be included in an approved death and disability insurance policy and is calculated in relation to the age of the employee's last birthday before total and permanent disablement and the lump sum as a multiple of the employee's salary on total and permanent disablement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 82-10(2).

Income Tax Assessment Act 1997 Section 82-130.

Income Tax Assessment Act 1997 Subsection 82-130(1).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(a).

Income Tax Assessment Act 1997 Subparagraph 82-130 (1)(a)(i).

Income Tax Assessment Act 1997 Subparagraph 82-130 (1)(a)(ii).

Income Tax Assessment Act 1997 Paragraph 82-130(b).

Income Tax Assessment Act 1997 Paragraph 82-130(c).

Income Tax Assessment Act 1997 Section 82-135.

Income Tax Assessment Act 1997 Paragraph 82-135(i).

Income Tax Assessment Act 1997 Section 82-140.

Income Tax Assessment Act 1997 Section 82-145.

Income Tax Assessment Act 1997 Section 82-150.

Income Tax Assessment Act 1997 Subsection 82-150(1).

Income Tax Assessment Act 1997 Paragraph 82-150(1)(a).

Income Tax Assessment Act 1997 Paragraph 82-150(1)(b).

Income Tax Assessment Act 1997 Paragraph 82-150(1)(c).

Income Tax Assessment Act 1997 Paragraph 82-150(1)(d).

Income Tax Assessment Act 1997 Subsection 995-1.

Reasons for decision

Summary

10. The payment of a special benefit (SB) payment to an employee in a middle management position where his or her employment is terminated on medical grounds will contain a tax-free component consisting of an invalidity segment determined under section 82-150 of the ITAA 1997 if all the conditions under that section are met. The employment must stop before the employee's last retirement date and 2 legally qualified medical practitioners have certified that, because of ill-health, it is unlikely that the employee can ever be gainfully employed in capacity for which he or she is reasonably qualified because of education, experience or training.

Detailed reasoning

11. Where a person's employment is terminated because of ill-health and the person receives an employment termination payment, part of the payment may be tax free. This component is called an invalidity segment.

12. Therefore, prior to determining if the payment includes an invalidity segment, the payment must be an employment termination payment.

Employment termination payment

13. Employment termination payments are defined in section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997). Subsection 82-130(1) declares:

A payment is an employment termination payment if:

(a) It is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's termination; and

(b) it is received no later than 12 months after the termination (but see subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

14. Section 82-135 of the ITAA 1997 provides that certain payments are not employment termination payments, including:

· superannuation benefits;

· payment for unused annual leave or unused long service leave;

· the tax-free part of a genuine redundancy payment or an early retirement scheme payment;

· reasonable capital payments for personal injury.

15. Therefore, it can be seen that three conditions need to be satisfied in order for the payment to be treated as an employment termination payment.

16. Failure to satisfy any of the three conditions will result in the payment not being considered an employment termination payment. Any termination payments received more than 12 months after the termination of employment will be taxed as ordinary income at marginal tax rates.

Payment received in consequence of the termination of employment

17. The first condition to be met is that there must be a payment that is made in consequence of the termination of employment of the taxpayer.

18. It should be noted that the phrase in consequence of the termination of your employment is not defined in the legislation. However, both the Courts and the Commissioner have considered the meaning of this phrase.

19. In Taxation Ruling TR 2003/13 the Commissioner has considered the meaning of the phrase in consequence of.

20. In paragraph 5 of TR 2003/13 the Commissioner states:

a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment follows as an effect or result of the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

21. As further stated by the Commissioner in paragraph 6 of TR 2003/13, there must be:

a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

22. The phrase in consequence of termination of employment has been interpreted by the courts in several cases.

23. Of note are the decisions made by the High Court in Reseck v. Federal Commissioner of Taxation¹ (Reseck) and the Full Federal Court in McIntosh v Federal Commissioner of Taxation² (McIntosh).

24. In Reseck, Justice Gibbs stated:

Within the ordinary meaning of the words a sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination. It is not my opinion necessary that the termination of the services should be the dominant cause of the payment.

25. While in the same case Justice Jacobs stated:

It was submitted that the words in consequence of import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a following on.

26. In looking at the phrase in consequence of the Full Federal Court in McIntosh considered the decision in Reseck.

27. Justice Brennan considered the judgments of Justice Gibbs and Justice Jacobs in Reseck and concluded that their Honours were both saying that a causal nexus between the termination and payment was required, though it was not necessary for the termination to be the dominant cause of the payment.

28. Suffice it to say that both Courts views were that for a payment to be made in consequence of the termination of employment it had to follow on as a result or effect of the termination of employment. Additionally, while it is not necessary to show that termination of employment is the sole or dominant cause, a temporal sequence alone would not be sufficient.

29. Furthermore, in Le Grand v Federal Commissioner of Taxation³ (Le Grand), the issue before the court was whether an amount received by the applicant as a result of accepting an offer of compromise in respect of claims brought by him against his former employer, in relation to the termination of his employment was in whole, or in part, an ETP. It was held that a settlement payment for litigation in relation to a taxpayers dismissal was an ETP.

30. Justice Goldberg stated:

I am satisfied that there is a sufficient connection between the termination of the applicants employment and the payment to warrant the finding that the payment was made in consequence of the termination of the applicants employment. I am satisfied that the payment was an effect or result of that termination in the sense that there was a sequence of events following the termination of the employment which had a relationship and connection which ultimately led to the payment.

31. Justice Goldberg concluded that the test for determining when a payment is made in consequence of the termination of employment is that which was articulated by Justice Gibbs in Reseck. Thus, for the payment to have been made in consequence of the termination of employment, the payment must follow as an effect or result of the termination of employment. As earlier stated in paragraph 6 of TR 2003/13, there must be 'a causal connection between the termination and the payment even though the termination need not be the sole or dominant cause of the payment'.

32. The Full Federal Court in Dibb v Federal Commissioner of Taxation⁴ (Dibb), has applied the above decisions in finding that the payment received by the taxpayer under a Deed of Release to settle various causes of action against the employer following the termination of employment was an ETP.

33. In paragraph 31 of TR 2003/13 the Commissioner states:

It is clear from the decision in Le Grand, that when a payment is made to settle a claim brought by a taxpayer for wrongful dismissal or claims of a similar nature that arise as a result of an employer terminating the employment of the taxpayer, the payment will have a sufficient causal connection with the termination of the taxpayer's employment. The payment will be taken to have been made in consequence of the termination of employment because it would not have been made but for the termination.

34. The essence of this analysis is that if the payment follows as an effect or a result from the termination of employment, the payment will be made in consequence of the termination of employment for the purposes of subparagraph 82-130(1)(a)(i) of the ITAA 1997. Hence, the payment will be an employment termination payment unless the payment is specifically excluded under section 82-135.

35. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

36. Therefore if an employee in a middle management position is medically discharged or medically retired under the relevant act and the employee is entitled to a payment of a SB, the payment is considered to be made in consequence of the termination of the employee's employment. The employee in the middle management position is unable to continue work due to their medical condition and consequently medically discharged from employment with the employer. The SB was paid when the employee terminated employment. The payment of a SB follows as an effect or a result from the termination of employment.

37. Therefore, the condition under subparagraph 82-130(1)(a)(i) of the ITAA 1997 has been satisfied.

Payment is received no later than 12 months after termination of employment

38. The second condition for the payment to meet the criteria is that the payment is paid to the employee no later than 12 months after the employee's employment was terminated.

39. This condition will be met if the payment of a SB is paid to the employee in a middle management position no later than 12 months after the employee's employment was terminated.

Not a payment mentioned in section 82-135 of the ITAA 1997

40. Section 82-135 of the ITAA 1997 lists payments that are not employment termination payments. These include (among others):

Ÿ superannuation benefits;

Ÿ unused annual leave or long service leave payments;

Ÿ the tax free part of a genuine redundancy payment or an early retirement scheme payment.

Ÿ reasonable capital payments for personal injury.

41. Paragraph 82-135(i) of the ITAA 1997 excludes payments or benefits that compensate or reimburses the taxpayer for or in respect of the particular injury. It should be noted that for an amount to meet the definition of consideration in paragraph 82-135(i) of the ITAA 1997, the payment must be for personal injury and be calculated by reference to the nature and extent of the injury or likely loss to the taxpayer.

42. From the facts, an employee is entitled to a SB when he or she is promoted to in a middle management position. The SB is equal to a percentage of total salary earnings for each completed term appointment. This SB accrues after each completed term and is paid out either when the employee's employment is terminated, medically discharged or if they are promoted to a senior executive position.

43. The payment of a SB is not for compensation or reimbursement to the employee in a middle management position for in respect of, personal injury, and is not calculated by reference to the nature and extent of the injury or likely loss to the employee. Therefore, it is considered that paragraph 82-135 (i) of the ITAA 1997 does not apply to the SB payment. Further, the payment bears no relation to any of the other payments mentioned in section 82-135 of the ITAA 1997. Accordingly, no part of the payment of a SB is specifically excluded from being an employment termination payment under section 82-135. Therefore the requirement in paragraph 82-130(1)(c) of the ITAA 1997 has been satisfied.

44. As discussed above payment of a SB is considered to be an employment termination payment as it satisfies all the conditions under subsection 82-130(1) of the ITAA 1997.

45. We will now determine whether a payment of a SB made to an employee in a middle management position, where the employment has been terminated on medical grounds will contain a tax-free component consisting of an invalidity segment determined under section 82-150 of the ITAA 1997.

Invalidity segment

46. Subsection 82-150(1) of the ITAA 1997 states that:

An employment termination payment includes an invalidity segment if:

(a) the payment was made to a person because he or she stops being gainfully employed; and

(b) the person stopped being gainfully employed because he or she suffered from ill-health (whether physical or mental); and

(c) the gainful employment stopped before the person's last retirement day; and

(d) 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in capacity for which he or she is reasonably qualified because of education, experience or training.

47. Section 995-1 of the ITAA 1997 defines being gainfully employed as follows:

gainfully employed means employed or self-employed for gain or reward in any business, trade, profession, vocation, calling, occupation or employment.

48. The conditions in paragraphs 82-150(1)(a), (b) and (c) of the ITAA 1997 will be satisfied if the payment of a SB was made by the employer to an employee in a middle management position because he or she stops being gainfully employed because he or she suffered from ill-health (whether physical or mental) and it was before the employee's last retirement day.

Certification from 2 legally qualified medical practitioners that the disability is likely to result in the taxpayer being unable ever to be employed.

49. In respect of the requirement in paragraph 82-150(1)(d) of the ITAA 1997, it must be demonstrated that the disability was such that it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

50. Therefore, paragraph 82-150(1)(d) of the ITAA 1997 requires that there must be the likelihood that the disability of the taxpayer will preclude the taxpayer from ever being employed in a role, for which the taxpayer is reasonably qualified.

51. Further, the requirement that the disability is likely to result in the taxpayer being unable ever to be employed in a capacity for which he or she is reasonably qualified extends to full-time employment, part-time or casual employment. A person who is not able to work full-time but can work part-time or casual in any employment for which the taxpayer is reasonably qualified will not receive the concessional component.

52. It should noted that the legally qualified medical practitioners when making the certification, should take into consideration any previous education, qualification or experience that the employee may have gained either in or outside employment with the employer. This is particularly relevant where the former employee is performing other work.

53. For example, if the employee has a part-time job or obtains subsequent employment (prior to the issuing of the medical certification) that involves the former employee using any education, qualification or experience they may have held prior to employment with the employer; or obtained whilst working for the employer even if the education, qualification or experience is not related to the employer.

54. If two medical practitioners provide certificates that attest to the employee being unable to ever be employed in a capacity for which he or she is reasonably qualified because of education, training or experience, it is considered that the final condition of subsection 82-150(1) of the ITAA 1997 has been satisfied.

55. Therefore, the payment of a SB will contain an Invalidity Segment under subsection 82-150(1) of the ITAA 1997 if all of the conditions under that subsection are met.

Components of an employment termination payment

56. An employment termination payment comprises the following components:

§ Tax free component this includes the pre-July 83 component (if any) and/or the invalidity segment (if any); and

§ Taxable component the amount remaining after deducting the tax free component from the total payment.

57. The tax-free component of an employment termination payment is not assessable income and is not exempt income (subsection 82-10(1) of the ITAA 1997). However, the taxable component is assessable income (subsection 82-10(2)) and subject to tax, depending on the person's age when the payment is received.

Calculation of invalidity segment

58. As noted above, the invalidity segment of an employment termination payment is included in the tax-free component (section 82-140 of the ITAA 1997). As a consequence, the invalidity segment is not assessable income and is not exempt income.

59. The amount of the invalidity segment is worked out by applying the formula in subsection 82-150(2) of the ITAA 1997:

Work out the amount of the invalidity segment by applying the following formula:

Amount of termination X Days to retirement / (Employment days + Days to retirement)

Where

days to retirement is the number of days from the day on which the person's employment was terminated to the last retirement day.

employment days is the number of days of employment to which the payment relates.

Tax treatment of taxable component

60. The amount in excess of the tax-free component is a taxable component of the employment termination payment as defined in section 82-145 of the ITAA 1997.

61. The taxable component is subject to tax depending on the person's age as follows:

* Preservation age is the age at which retirees can access their superannuation benefits. This will be 55 for persons born before 1 July 1960 and between 55 and 60 for persons born after 30 June 1960.

62. The $140,000 cap on concessionally taxed employment termination payments is indexed annually to average weekly ordinary time earnings. For the 2013-14 income year, the cap is $180,000.

63. The taxable components of all employment termination payments received in an income year are counted towards this cap. Any tax-free amounts are not counted towards the cap.

Conclusion

64. The payment of a SB to an employee in a middle management position, where the employment has been terminated on medical grounds, will contain a tax-free component consisting of an invalidity segment determined under section 82-150 of the Income Tax Assessment Act 1997 (ITAA 1997) if all the conditions under that section are met.

¹ (1975) 49 ALJR 370; (1975) 6 ALR 642; (1975) 5 ATR 538; (1975) 75 ATC 4213; (1975) 133 CLR 45

² (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325

³ [2002] FCA 1258; (2002) 124 FCR 53; (2002) 195 ALR 194; (2002) 2002 ATC 4907; (2002) 51 ATR 39

⁴ [2004] FCAFC 126; (2004) 207 ALR 151; (2004) 2004 ATC 4555; (2004) 55 ATR 786

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