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Subject: Invalidity payment

Question:

Should a portion of payment paid on termination of employment be treated as an invalidity payment within the meaning of section 27G of the Income Tax Assessment Act 1936?

Advice/Answers:

Yes.

This ruling applies for the following period:

1 July 2006 to 30 June 2007

The scheme commenced on:

1 July 2006

Relevant facts:

Your client is under 55 years of age.

Your client commenced employment with an employer (the employer).

Your client was employed after graduating.

Prior to commencing with the employer your client worked in a casual capacity whilst a full time student. She had completed her Higher School certificate prior to joining the employer. She has had no other education or training prior to joining the employer.

Your client is a member of an employer superannuation scheme.

Your client suffered a workplace injury while employed.

Your client was not provided with any rehabilitation or retraining nor was she offered any alternative employment options with the employer.

The employer advised your client that she was permanently unfit for her duties and was to have her employment terminated. She was also advised as to what date her last day of service would be. Further, the letter stated that a medical panel had recommended that your client's employment be terminated.

Your client's employment was terminated due to her illness on the said date and she received a payment from the employer:

There is no other date on which your client would have retired from the employer prior to age 65.

After her discharge from the employer your client was employed by a company to fill a twelve month leave position.

This job included various duties which your client found very difficult due to her illness and resigned in less than six months.

The only employment income your client has received since her discharge from the employer is from worker's compensation payments and she will continue to be eligible to receive these payments until she reaches pension age.

You have provided medical certificates from two legally qualified medical practitioners regarding your client's illness.

Assumptions:

None.

Relevant legislative provisions:

Income Tax Assessment Act 1936 Subsection 27A(1).

Income Tax Assessment Act 1936 Subsection 27G.

Reasons for decision

Summary

Part of the total and permanent disability benefit received by your client is exempt from tax as a post-June 1994 invalidity component of an eligible termination payment (ETP). The remainder is taxed as an ETP at no more than 31.5%.

Detailed reasoning

Invalidity payment

Where a person's employment is terminated because of ill-health and the person receives an ETP, part of the payment may be tax free. This component is called a post-June 1994 invalidity component for payments made after 30 June 1994 and before 1 July 2007.

Therefore, prior to determining if the payment includes a post-June 1994 invalidity component, the payment must be an ETP.

1. Payment in consequence of termination of employment:

The ETP provisions are contained in subdivision AA of Part III, Division 2 of the Income Tax Assessment Act 1936 (ITAA 1936). ETPs are defined in subsection 27A(1) of the ITAA 1936 and include payments made in consequence of the termination of employment.

A lump sum payment will constitute an ETP if it comes within paragraph (a) of the definition of ETP in subsection 27A(1) of the ITAA 1936. That provision states:

"eligible termination payment", in relation to a taxpayer means -

(a) any payment made in respect of the taxpayer in consequence of the termination of any employment of the taxpayer, other than a payment …

(i) made from a superannuation fund in respect of the taxpayer by reason that the taxpayer is or was a member of the fund;…

Paragraph (b) of the ETP definition in subsection 27A(1) states:

any payment made from a superannuation fund in respect of the taxpayer by reason that the taxpayer is or was a member of the fund…

Payment is made in consequence of the termination of employment

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

In Taxation Ruling TR 2003/13 the Commissioner considered the meaning of the phrase 'in consequence of' as interpreted by the Courts.

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.

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.

Also in paragraph 5 of TR 2003/13 the Commissioner notes that the Courts have considered the meaning of the words in consequence of in several cases. Of note are the decisions made by the Full Bench of the High Court in Reseck v. Federal Commissioner of Taxation (1975) 49 ALJR 370; (1975) 6 ALR 642; (1975) 5 ATR 538; (1975) 75 ATC 4213; (1975) 133 CLR 45 (Reseck) and the Full Federal Court in McIntosh v Federal Commissioner of Taxation (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325 (McIntosh).

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.

In this case, it is considered that the payment was made in consequence of the termination of your client's employment. Your client was unable to continue work due to her being permanently unfit for general and alternative duties with the employer. The employer, after taking into account your client's case history and a recommendation by the medical panel, approved your client's termination of employment and the payment of a disability benefit under an award (the Award).

The payment received by your client from the employer would not have been approved and paid unless your client's employment was terminated and in this case the termination was based on medical grounds.

Therefore, the total payment is considered to have been made in consequence of the termination of your client's employment and satisfies the first condition under section 27G of the ITAA 1936.

1. Post-June 1994 Invalidity Component:

The post-June 1994 invalidity component is defined in subsection 27A(1) of the ITAA 1936 as:

…so much of the ETP that consists of, or is attributable to, an invalidity payment made on or after 1 July 1994.

An 'invalidity payment' is further defined in subsection 27A(1) of the ITAA 1936 as:

in relation to a taxpayer, means an invalidity payment in relation to the taxpayer ascertained under section 27G.

Whether a payment is an 'invalidity payment' is determined by reference to section 27G of the ITAA 1936. That provision states:

Where:

(a) an eligible termination payment is made in relation to a taxpayer in consequence of the termination of any employment of the taxpayer; and

(b) the termination of the employment of the taxpayer occurred:

(i) because of:

(A) if the eligible termination is made before 1 July 1994 - the taxpayer's physical or mental incapacity to engage in that employment; or

(B) if the eligible termination payment is made on or after 1 July 1994 - the disability of the taxpayer, where 2 legally qualified medical practitioners have certified that the disability is likely to result in the taxpayer being unable ever to be employed in a capacity for which the taxpayer is reasonably qualified because of education, training or experience; and

(ii) before the last retirement date in relation to the employment;

so much of the eligible termination payment as is equal to the amount ascertained in accordance with the formula

where:

A is the amount of the eligible termination payment;

B is the number of whole days in the period from the date on which the termination occurred to the last retirement date; and

C is the aggregate of the number of whole days in the eligible service period in relation to the eligible termination payment and the number of whole days represented by component B;

is an invalidity payment in relation to the taxpayer.

There are three conditions that must be satisfied, and failure to satisfy any one will result in the payment not being an invalidity payment. It is proposed to deal with each condition in turn.

(i) Made in consequence of the termination of any employment of the taxpayer

It has already been determined above that the payment is an ETP and was made in consequence of the termination of employment.

Therefore the first condition under paragraph 27G(a) of the ITAA 1936 is satisfied.

(ii) Termination of employment occurred because of the disability of the taxpayer and certified by two legally qualified medical practitioners

There are two requirements under this condition in sub-subparagraph 27G(b)(i)(B) of the ITAA 1936 for a payment to be an invalidity payment:

a) the termination of employment occurred because of the disability of the taxpayer; and

b) two legally qualified medical practitioners have provided certification to state that because of the disability the taxpayer is unlikely to be ever employed in a capacity for which the taxpayer is qualified because of education, experience and training.

As stated above, the termination of employment was because of a medical condition i.e. a disability. Therefore the first condition is satisfied.

Prior to 1 July 1994, it had only been necessary for the termination of employment to occur because the taxpayer was physically or mentally incapacitated and therefore unable to engage in that employment. It did not require there be incapacity to engage in any employment. However, amendments made to section 27G of the ITAA 1936, by the Taxation Laws Amendment (Superannuation) Act 1992 require the incapacity to prevent the taxpayer ever being able to undertake any employment for which the taxpayer is reasonably qualified.

The EM to the Taxation Laws Amendment (Superannuation) Bill 1992 confirms this. In explaining the test for invalidity, the EM stated the following:

To clarify the test for incapacity and to place the onus of determining invalidity on legally qualified medical practitioners, from 1 July 1994 the incapacity of the person will have to be certified by two medical practitioners.

…the invalidity payment concession is extended only to people who are unable to undertake any form of employment for which they are reasonably qualified. A person who is unable to continue his or her current employment, but is able to undertake other appropriate employment, will not have access to the concession.

Therefore, a person who is unable to continue to perform the duties of his or her current employment, but is able to undertake other appropriate employment for which they are reasonably qualified, would not now satisfy the condition in section 27G of the ITAA 1936.

However, the use of the term 'appropriate employment' in the EM suggested the intention that the term 'reasonably qualified' be interpreted as meaning neither over nor under qualified to any significant extent.

Even if a taxpayer's employment is terminated by reason of disability, this does not mean that the second part of test for invalidity is satisfied. The two parts are independent. The fact that the medical practitioners have to determine invalidity does not mean that the medical practitioners have to determine the reason for termination.

A person's employment can be terminated because of disability, irrespective of whether two medical practitioners form an opinion as to whether the disability will prevent the taxpayer from ever being able to be employed in a capacity for which the taxpayer is reasonably qualified because of education, training or experience.

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.

In this case, after examining the contents of the medical reports provided from two legally qualified medical practitioners, it is considered that the two reports satisfy the requirement prescribed in section 27G of the ITAA 1936.

Both doctors state in their reports that your client is unable to be employed in any capacity for which she is reasonably qualified because of education, experience or training.

The words of section 27G do not require the Commissioner to be satisfied as to the capacity of the taxpayer for employment, it being sufficient that two medical practitioners so certify.

Therefore, as two legally qualified medical practitioners have certified that the taxpayer is unlikely to be employed in the capacity for which he is qualified because of education, experience and training, the second condition under section 27G of the ITAA 1936 has been satisfied.

(iii) Termination of employment occurred before the last retirement date

The third condition for a payment to qualify as an invalidity component is that it was made before the taxpayer's last retirement date. The payment was made well before the normal retirement age of 65. Therefore, the condition of section 27G of the ITAA 1936 has been satisfied.

Calculation of the post-June 1994 invalidity component:

The amount calculated in the above mentioned formula is the invalidity component included in the ETP and it is tax free. The remaining amount of is an ETP which is to be included in your client's income tax return. As your client had not reached her preservation age, this amount will be taxed at no more than 30% (plus Medicare Levy).

You will need to lodge an objection to your client's 2006-07 tax assessment in order to reflect the above by writing to your local Tax Office.

Extension of time to lodge objection

There are time limits for lodging objections to a notice of assessment. Most taxpayers need to request an amendment within two years of the day the Commissioner issues a notice of the assessment. However, some taxpayers have a four year amendment period.

Generally a taxpayer will have a four year amendment period if, for example:

Ÿ they carried on a business and are not a small business entity for that year

Ÿ they were a partner in a partnership that was carrying on a business and the partnership was not a small business entity for that year

Ÿ they received a trust distribution unless the trust was a small business entity for that year or the trustee of the trust (in that capacity) was a full self-assessment taxpayer (for example, the trustee was a company).

A taxpayer may lodge an objection after the objection period has expired, but must include a written request asking the Commissioner to extend the due date for lodging an objection for that year if the objection is to be considered.

In this case your client's assessment for the 2006-07 income year issued on 12 November 2007. Therefore the objection was to be lodged within two years of the assessment issuing.

However, as the period for lodging an objection has passed you will have to request an extension of time to lodge the objection.