Edited version of your written advice

Authorisation Number: 1012750380262

Ruling

Subject: Employment termination payment - invalidity segment.

Questions

1. Does the employment termination payment you received in the 2013-14 income year include an invalidity segment in accordance with section 82-150 of the Income Tax Assessment Act 1997 (ITAA 1997)?

2. Will a concessional tax treatment apply to the payment you received in the 2013-14 income year for unused annual leave?

Answer

1. Yes

2. Yes

This ruling applies for the following period:

Income year ended 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

The taxpayer was employed in a specific job with an employer.

The taxpayer developed an illness and has been unable to attend work for a period of time.

Two legally qualified medical practitioners have each certified that the taxpayer is unfit to work due to their illness and that it is unlikely for the taxpayer to ever be gainfully employed in the capacity for which the taxpayer is reasonably qualified because of education, experience or training.

The taxpayer's employment was terminated during the 2013-14 income year. According to a letter from the employer, the termination was initiated by the employer and occurred as a result of the taxpayer's ill health.

As a consequence of the taxpayer's termination, the taxpayer received an employment termination payment from the employer for pay in lieu of notice.

In addition, the taxpayer also received a payment from the employer for unused annual leave and leave loading that they had accrued.

The taxpayer has reached their preservation age.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 27G

Income Tax Assessment Act 1997 section 82-10

Income Tax Assessment Act 1997 subsection 82-10(3)

Income Tax Assessment Act 1997 subsection 82-130(1)

Income Tax Assessment Act 1997 paragraph 82-140(a)

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 82-150(2)

Income Tax Assessment Act 1997 section 83-10

Income Tax Assessment Act 1997 subsection 83-10(2)

Income Tax Assessment Act 1997 subsection 83-10(3)

Income Tax Assessment Act 1997 section 83-15

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Summary

The amount calculated under the formula is exempt from tax as an invalidity segment of an employment termination payment. The remaining amount is the taxable component of the employment termination payment to be included in the taxpayer's income tax return for the 2013-14 income year.

The taxpayer is entitled to a tax offset to ensure that the rate of tax on the unused annual leave payment they received from the employer does not exceed 30%.

Detailed reasoning

Invalidity Segment

When a person receives an employment termination payment under subsection 82-130(1) of the Income Tax Assessment Act 1997 (ITAA 1997), part of the payment may be tax free if the termination occurred as a result of the person's ill health. This component is called an invalidity segment.

In this case, the facts show that the lump sum payment the taxpayer received upon the termination of their employment on medical grounds is an employment termination payment.

In order for any part of the payment to include an invalidity segment and be tax free, the payment must satisfy subsection 82-150(1) of the ITAA 1997, which states:

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.

Payment for stopping gainful employment

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.

According to the facts of the case, the taxpayer was gainfully employed by the employer until their employment was terminated during the 2013-14 income year.

The payment the taxpayer received was a payment for pay in lieu of notice and as such is considered to be a payment that was made to the taxpayer because they stopped being gainfully employed. The condition under paragraph 82-150(1)(a) of the ITAA 1997 is thus satisfied.

Employment termination occurred because of ill-health

The requirement under paragraph 82-150(1)(b) of the ITAA 1997 is that the termination of employment resulted from the taxpayer's ill-health; that is, the ill-health was the immediate cause for the termination of the taxpayer's employment.

In this case, the facts show that the taxpayer's employment was terminated on medical grounds. A letter from the employer states that the termination was initiated by the employer on grounds of the taxpayer's ill health. Therefore, it is considered that this requirement is satisfied.

Termination of employment occurred before 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 during the 2013-14 income year, well before the taxpayer's normal retirement age. Therefore, the condition under paragraph 82-150(1)(c) of the ITAA 1997 has been satisfied.

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

In respect of the final requirement, it must be demonstrated that the disability at the time of termination was such that:

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.

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.

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 the section that applied prior to 1 July 2007, 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 paragraph 82-150(1)(d) of the ITAA 1997, which is the rewritten provision for 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 the 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 it is considered that there are two reports that satisfy the requirement prescribed in paragraph 82-150(1)(d) of the ITAA 1997.

Two legally qualified medical practitioners have certified, in two medical certificates, that the taxpayer is suffering from a medical condition and that it is unlikely that the taxpayer can ever be gainfully employed in any capacity for which they are reasonably qualified because of education, experience and training. Furthermore, in making the statement, they have both considered not just the taxpayer's position with the employer, but also the possibility of the taxpayer working in other areas.

The final condition of subsection 82-150(1) of the ITAA 1997 is thus satisfied.

Taxation of the employment termination payment

An employment termination payment is comprised of the following components:

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

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

As the taxpayer has satisfied the requirements for the payment of an invalidity segment, a portion of the employment termination payment received from the employer will be tax free under paragraph 82-140(a) of the ITAA 1997

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 employment x ____________Days to retirement__________

Termination payment 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.

Therefore, the amount calculated under the formula above as the invalidity segment is tax free.

The remaining is a taxable component to be included in the taxpayer's income tax return for the 2013-14 income year as assessable income under section 82-10 of the ITAA 1997.

Note however that subsection 82-10(3) of the ITAA 1997 entitles the taxpayer to a tax offset that ensures that the rate of income tax on the taxable component, up to the 'applicable cap' amount does not exceed:

(a) if you are your preservation age or older on the last day of the income year in which you receive the payment -15%; or

(b) otherwise 30%

Note: The remainder of the taxable component is taxed at the top marginal rate in accordance with the Income Tax Rates Act 1986

Taxation of the unused annual leave payment

The payment the taxpayer received from the employer for unused annual leave and leave loading that the taxpayer had accrued is an 'unused annual leave payment' under subsection 83-10(3) of the ITAA 1997.

According to subsection 83-10(3) of the ITAA 1997:

(3) A payment that you receive in consequence of the termination of your employment is an unused annual leave payment if:

(a) it is for annual leave you have not used; or

(b) it is a bonus or other additional payment for annual leave you have not used; or

(c) it is for annual leave, or is a bonus or other additional payment for annual leave, to which you were not entitled just before the employment termination, but that would have been made available to you at a later time if it were not for the employment termination.

Unused annual leave payments are included in the taxpayer's assessable income under section 83-10(2) of the ITAA 1997.

However, according to section 83-15 of the ITAA 1997:

You are entitled to a tax offset to ensure that the rate of tax on an unused annual leave payment does not exceed 30%, to the extent that:

(a) the payment was made in connection with a payment that includes, or consists of, any of the following:

(i) a genuine redundancy payment;

(ii) an early retirement scheme payment;

(iii) the invalidity segment of an employment termination payment or superannuation benefit; or

(b) the payment was made in respect of employment before 18 August 1993

As it has already been established that the employment termination payment that the taxpayer received includes an invalidity segment, the unused annual leave payment that the taxpayer received will be concessionally taxed in the manner outlined above.