Edited version of your written advice

Authorisation Number: 1013094052851

Date of advice: 27 September 2016

Ruling

Subject: Tax treatment of invalidity pensions

Question 1

Are the payments of the invalidity pension paid to you under the rules of the Military Superannuation and Benefits Scheme (MSBS) established by trust deed under the Military Superannuation and Benefits Act 1991 (MSBA) superannuation benefits as that term is defined in section 307-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Yes.

Question 2

If yes to the previous question, are the payments of the invalidity pension paid to you excluded by section 307-10 of the ITAA 1997 from the definition of superannuation benefit in section 307-5 of the ITAA 1997?

Answer 2

No.

Question 3

If no to the previous question, does the invalidity pension constitute a superannuation income stream as that term is defined in section 307-70 of the ITAA 1997 and regulation 995-1.01(1) of the Income Tax Assessment Regulations 1997 (ITAR)?

Answer 3

Yes.

Question 4

If yes to the previous question, can you make the election in regulation 995-1.03 of the ITAR, before a particular payment of the invalidity pension is made, that the payment is not to be treated as a superannuation income stream benefit?

Answer 4

Yes.

Question 5

Is the invalidity pension payable to you under the rules of the MSBS an employment termination payment?

Answer 5

No.

Question 6

Is the invalidity benefit paid from the MSBS paid in respect of an interest that is a defined benefit interest under section 291-175 of the ITAA 1997?

Answer 6

Yes.

This ruling applies for the following periods:

Income year ending 30 June 2014;

Income year ending 30 June 2015;

Income year ending 30 June 2016; and

Income year ending 30 June 2017

The scheme commences on:

1 July 2013

Relevant facts and circumstances

As a member of the ADF, you became a member of the MSBS. The MSBS is a scheme which was established to provide benefits that are payable when an individual retires from the ADF.

Amongst other things, the MSBS Rules provide for the payment of an invalidity pension to certain individuals who have been retired because of their invalidity.

To determine whether an invalidity pension is payable, the MSBS Rules provide for a mechanism by which a determination is made of a particular individual's capacity/incapacity to engage in civil employment after their retirement from the ADF: rule 22 MSBS Rules. Under that rule, an individual is assessed as having a Class A, Class B or Class C incapacity for civil employment.

The MSBS Rules provide that a person whose incapacity for civil employment is classified as Class A is eligible for an invalidity pension, the starting amount for which is worked out having regard to an amount called the employer benefit: rule 27 MSBS Rules. A person whose incapacity for civil employment is classified as Class B is entitled to a pension of a different amount, which in very broad terms, may be half of the amount payable to a Class A recipient: rule 28 MSBS Rules. However, no invalidity pension is payable to a person whose incapacity for civil employment is classified as Class C: rule 31 MSBS Rules.

In very simple terms, the 'employer benefit' is worked out having regard to your final average salary and your eligible service period. Schedule 8 to the MSBS Rules sets out the rules for the calculation of the employer benefit for some members, including a person who is retired from the ADF because of invalidity. Schedule 5 to the MSBS Rules sets out the rules used to calculate the rate of pension that is payable by conversion from the amount of the employer benefit.

The MSBS Rules require an individual to undergo periodical reviews of their level of incapacity for civil employment: rule 25 MSBS Rules. The MSBS Rules generally provide that if an individual's level of incapacity for civil employment is adjusted to the extent that they are reclassified to another classification, the amount payable may be adjusted. If an individual is reclassified to Class C, the invalidity pension that had been payable to them (as either a Class A or Class B individual) is cancelled and the individual will have a preserved benefit of the amount of their employer benefit: rule 29 MSBS Rules.

However, an individual who has reached the age of 55, cannot be reclassified to Class C incapacity for civil employment: subrule 23(2) MSBS Rules.

Upon becoming entitled to receive an invalidity pension under the MSBS, an amount equal to the funded employer benefit is paid by the CSC to the Commonwealth and the invalidity pension is payable to the individual by the Commonwealth from the Consolidated Revenue Fund: section 13 MSBA.

If an invalidity pension that was payable to an individual who was classified as having a Class A or Class B incapacity for civil employment is cancelled because the individual is reclassified to Class C, the Commonwealth must pay to the CSC an amount equal to the individual's funded employer benefit: section 15 MSBA.

The CSC is currently withholding amounts from your invalidity pension on the basis that each fortnightly payment of the pension is a superannuation income stream benefit that you are liable to include in your assessable income.

You are under your preservation age.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 82-130

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

Income Tax Assessment Act 1997 paragraph 82-130(1)(b)

Income Tax Assessment Act 1997 paragraph 82-130(1)(c)

Income Tax Assessment Act 1997 section 82-135

Income Tax Assessment Act 1997 paragraph 82-135(a)

Income Tax Assessment Act 1997 paragraph 82-135(b)

Income Tax Assessment Act 1997 paragraph 82-130(1)(c)

Income Tax Assessment Act 1997 section 82-135

Income Tax Assessment Act 1997 section 291-175

Income Tax Assessment Act 1997 subsection 291-175(1)

Income Tax Assessment Act 1997 subsection 291-175(2)

Income Tax Assessment Act 1997 section 301-35

Income Tax Assessment Act 1997 section 301-40

Income Tax Assessment Act 1997 section 301-120

Income Tax Assessment Act 1997 section 307-5

Income Tax Assessment Act 1997 subsection 307-5(1)

Income Tax Assessment Act 1997 section 307-10

Income Tax Assessment Act 1997 paragraph 307-10(a)

Income Tax Assessment Act 1997 section 307-145

Income Tax Assessment Act 1997 subdivision 307-B

Income Tax Assessment Act 1997 subsection 995-1(1)

Income Tax Assessment Regulations 1997 subregulation 995-1.01(1)

Income Tax Assessment Regulations 1997 subregulation 995-1.01(2)

Income Tax Assessment Regulations 1997 regulation 995-1.03

Income Tax Assessment Regulations 1997 subparagraphs 995-1.03(a)(i)-(iv)

Superannuation Industry (Supervision) Act 1993 section 10

Superannuation Industry (Supervision) Regulations 1994 subregulation 1.06(1)

Reasons for decision

Detailed reasoning

Question 1

Are the payments of the invalidity pension paid to you under the rules of the Military Superannuation and Benefits Scheme (MSBS) established by trust deed under the Military Superannuation and Benefits Act 1991 (MSBA) superannuation benefits as that term is defined in section 307-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Yes

Reasons

Item 1 of the table in subsection 307-5(1) of the ITAA 1997 effectively states that a 'superannuation benefit' includes a payment made to you from a superannuation fund because you are a fund member.

'Superannuation fund' is defined in subsection 995-1(1) of the ITAA 1997 to have the meaning given by section 10 of the Superannuation Industry (Supervision) Act 1993 (SISA).

Paragraph (b) of the superannuation fund definition in subsection 10(1) of the SISA refers to a 'public sector superannuation scheme.' This term is also defined in that subsection to include a scheme for the payment of superannuation, retirement or death benefits, where the scheme is established by or under a law of the Commonwealth or the government of a State or Territory.

The MSBS is established under the law of the Commonwealth to pay superannuation, retirement or death benefits. In particular, it provides for benefits that are in the nature of superannuation benefits that are payable on retirement from the ADF, including where that retirement is due to invalidity. It is therefore a superannuation fund for both SISA and income tax purposes.

In Michael James Hammerton v Comcare Australia [1995] AATA 63, the Administrative Appeals Tribunal reached a similar conclusion about the scheme established under the Defence Force Retirement and Death Benefits Act 1973 (DFRDB Act). That Act also provides for certain invalidity benefits to retired service personnel. Section 125 of that Act, like the MSBA, provides that all benefit payments are made by the Commonwealth and are made out of the Consolidated Revenue Fund.

Further, the invalidity pension payments are made because the recipients are, or have been, fund members. Each individual's entitlement to the benefits arises because they were a fund member who retired due to invalidity.

For these reasons we consider that the MSBS invalidity pensions are superannuation benefits as defined in section 307-5 of the ITAA 1997.

Question 2

If yes to the previous question, are the payments of the invalidity pension paid to you excluded by section 307-10 of the ITAA 1997 from the definition of superannuation benefit in section 307-5 of the ITAA 1997?

Answer 2

No

Reasons

Paragraph 307-10(a) of the ITAA 1997 excludes from the definition of 'superannuation benefit' amounts payable under an income stream because of the person's temporary inability to engage in gainful employment.

The MSBS invalidity pension is paid because a member is retired from the ADF on the ground of invalidity. It is not paid because of the person's temporary inability to engage in gainful employment but rather on the assessment of their incapacity in relation to civil employment.

The assessment of incapacity determines whether an individual is entitled to a pension and if so how much is payable as the pension. On review, the assessment of incapacity can also determine whether a different amount is payable or whether a pension should be cancelled (if the individual is reclassified as having Class C incapacity).

The payment of an invalidity pension under the MSBS occurs when there is a permanent, not temporary incapacity. An individual's degree of incapacity must be such that first, the individual is retired from the ADF. Secondly, the degree of incapacity that is necessary for an individual to be paid an invalidity pension is such that it has diminished the individual's capacity to undertake the kinds of civil employment which a person with the vocational, trade and professional skills, qualifications and experience the particular individual has and that they might reasonably undertake: see for example, rules 22 and 23 of the MSBS Rules.

We consider the MSBS invalidity payments do not relate to temporary disability or temporary incapacity and they are therefore not excluded from being superannuation benefits by paragraph 307-10(a) of the ITAA 1997.

Question 3

If no to the previous question, does the invalidity pension constitute a superannuation income stream as that term is defined in section 307-70 of the ITAA 1997 and regulation 995-1.01(1) of the Income Tax Assessment Regulations 1997 (ITAR)?

Answer 3

Yes

Reasons

Superannuation benefits are either superannuation income stream benefits or superannuation lump sums (Subdivision 307-B of the ITAA 1997).

A superannuation income stream benefit is relevantly 'a payment from an interest that supports a superannuation income stream, other than a payment to which regulation 995-1.03 of the ITAR applies: subsection 307-70(1) and (2) of the ITAA 1997 and subregulation 995-1.01(2) of the ITAR.

A definition of "superannuation income stream" is set out in subregulation 995-1.01(1) of the ITAR. On the issue of whether these MSBS pensions are superannuation income streams, an 'income stream' is a superannuation income stream if it is taken to be a pension for the purposes of the SIS Act in accordance with subregulation 1.06(1) of the Superannuation Industry (Supervision) Regulations 1994 or SISR.

The expression 'income stream' is not defined by either the income tax or superannuation laws. It must be given its ordinary meaning. We consider that an income stream is a series of periodic payments that relate to each other and that are payable over an identifiable period of time.

The invalidity pension payable under the MSBS amounts to such a series of fortnightly payments.

Having examined the terms under which the invalidity pension is payable under the MSBA and MSBS, we are satisfied that the invalidity pension is a pension that meets the requirements set out in subregulation 1.06(1) of the SISR.

You refer in your application to the circumstances in which the invalidity pension may vary under the MSBS rules and point to the conditions in paragraph 995-1.03 of the ITAR in order to conclude that the invalidity pension is not a superannuation income stream. However, we note that regulation may only affect whether a particular payment from a superannuation income stream is a superannuation income stream benefit or a superannuation lump sum. It has no effect on whether a person's benefits paid from their superannuation fund are a superannuation income stream or not. Regulation 995-1.03 only applies if a member's benefits are being paid as a superannuation income stream as defined.

Question 4

If yes to the previous question, can you make the election in regulation 995-1.03 of the ITAR, before a particular payment of the invalidity pension is made, that the payment is not to be treated as a superannuation income stream benefit?

Answer 4

Yes

Reasons

Regulation 995-1.03 of the ITAR effectively allows a person in receipt of a superannuation income stream to elect to have a payment made from the income stream be treated as a superannuation lump sum instead of a superannuation income stream benefit (provided the person makes the election before the payment is made). However, an election under regulation 995-1.03 of the ITAR may only be made if the conditions to which the superannuation income stream is subject permit the amount of payments in a year to vary other than in the circumstances set out in sub-paragraphs (a)(i)-(iv). Effectively this means that an election can only be made if the payment amount in a year is capable of being varied other than by way of: indexation under the pension rules; the application of the family law splitting rules; the commutation of the income stream; or the payment of an assessment of excess contributions tax.

Rule 23 permits a person who has been classified under Rule 22 to be reclassified under Rule 22 at a future time. For example, a retiree who was classified as Class A under Rule 22 may, where the requirements of Rule 23 are met, be reclassified as Class B or Class C at some later time (and vice versa).

In the case of a person in receipt of an MSBS invalidity pension who is reclassified Class A or Class B, this effectively means the annual payment amount of their pension will change significantly given the annual amount of a Class B invalidity pension may in general terms equate to only half the annual amount payable as a Class A invalidity pension.

We consider that in the circumstance where the annual amount of payments from an MSBS invalidity pension is altered in response to the application of Rule 23, this reflects a circumstance other than one set out in sub-paragraphs 995-1.03(a)(i)-(iv). Accordingly a person in receipt of an MSBS invalidity pension may make an election under regulation 995-1.03 or the ITAR 1997 in respect of a payment provided they make the election before the payment from their pension is made.

Question 5

Is the invalidity pension payable to you under the rules of the MSBS an employment termination payment?

Answer 5

No

Reasons

Under section 82-130 of the ITAA 1997, a payment is an employment termination payment if each of three conditions is met:

• it is received by a person in consequence of the termination of the person's employment: subparagraph 82-130(1)(a)(i),

• it is received no later than 12 months after that termination: paragraph 82-130(1)(b), and

• it is not excluded from being an employment termination payment by section 82-135 of that Act: paragraph 82-130(1)(c).

Even in the event it could be said that payments made from the MSBS invalidity pension meet the first of these two conditions, under paragraph (a) of section 82-135 of the ITAA 1997, the payment of a superannuation benefit is not an employment termination payment. For the reasons set out for question 1 of this ruling, the invalidity pension payments are superannuation benefits. Therefore, your invalidity pension payments are excluded from the definition of employment termination payment under paragraph 82-135(a) of the ITAA 1997.

Further, paragraph 82-135(b) of the ITAA 1997 provides that the payment of a pension is not an employment termination payment. As the word 'pension' as used in that paragraph is not defined, it takes its ordinary meaning.

In Michael James Hammerton v Comcare Australia [1995] AATA 63, the Administrative Appeals Tribunal decided that the pension payable under the DFRDB scheme was a pension within the ordinary meaning of that word. We consider that this position can be consistently applied to the payments of the MSBS invalidity pension.

Consequently, all of the fortnightly pension payments received by you are also excluded from the definition of employment termination payment under paragraph 82-135(b) of the ITAA 1997.

We note that because the invalidity pension is a pension within the ordinary meaning of the term "pension", it may be included in assessable income as ordinary income under section 6-5 of the ITAA 1997 if it was not otherwise regarded as a superannuation benefit.

Question 6

Is the invalidity benefit paid from the MSBS paid in respect of an interest that is a defined benefit interest under section 291-175 of the ITAA 1997?

Answer 6

Yes

Reasons

Subsection 291-175(1) of the ITAA 1997 provides that an individual's superannuation interest is a "defined benefit interest" to the extent it defines the individual's entitlement to superannuation benefits payable from the interest by reference to (relevantly for this advice):

(a) the individual's salary or allowance in the nature of salary at a particular date or averaged over a period; …

(b) specified conversion factors.

However, subsection 291-175(2) provides that the interest is not a defined benefit interest if it defines that entitlement solely by reference to one or more of the following:

(a) disability superannuation benefits;

(b) superannuation death benefits;

(c) payments of amounts mentioned in paragraph 307-10(a).

As a member of the MSBS, an individual enjoys a range of potential prescribed entitlements under the scheme where the actual entitlement derived by the individual or their dependants upon the individual ceasing to be a member of the scheme is contingent upon the happening of some future event. Specifically, while a member of the scheme an individual has a contingent entitlement to benefits variously payable upon retirement, resignation, retrenchment and invalidity. Their dependants may also have a contingent entitlement to receive payments from the scheme on their death.

In the case of these contingent entitlements, the member's employer benefit is derived under the scheme rules by a formula that references their final average salary and various other factors such as their years of service. In the event the benefit paid from the scheme is a pension, the annual pension amount is further derived by the application of specified conversion factors. Accordingly, we consider that a member's interest in the MSBS is a defined benefit interest under subsection 291-175(1) of the ITAA 1997.

Further, as a member of the MSBS has a contingent entitlement to benefits that may be paid on retirement or resignation or retrenchment as well as upon invalidity or death, subsection (2) cannot apply as their interest in the MSBS is not defined 'solely' by reference to disability superannuation benefits or death benefits as defined and, for the reasons set out in the answer to question 2, the invalidity pensions do not give rise to payments to which paragraph 307-10(a) applies.

This conclusion is not affected by the fact a person is actually in receipt of an invalidity pension. This is because the right to the pension itself is not the only right the person has in the scheme. For example, in the circumstances where a person has been receiving a pension but is reclassified to Class C incapacity for civil employment and the pension is cancelled, the Commonwealth must pay an amount of funded employer benefit back to CSC. The person then has an entitlement to the employer benefit again and that benefit is not any one of the kinds specified in subsection 291-175(2) of the ITAA 1997.

Calculation of your lump sum payment in arrears offset

Which year was the income derived?

Taxation Ruling TR 98/1 considers the appropriate method of determining when income is derived under subsection 6-5(2) of the ITAA 1997 where income is earned in one tax year but received in another. Paragraph 42 of TR 98/1 states that salary and wages or other employment remuneration is assessable on a receipts basis. This is irrespective of whether that income relates to a past or future income period.

Lump sum payments in arrears are payments that relate to an earlier income year or years. Therefore, a lump sum amount of assessable income in arrears will be included in a taxpayer's taxable income in the year in which it is received even when it relates to an earlier year of income.

Application to your circumstances

As your lump sum payment arose from back pay of salary, it is considered to be assessable under section 6-5 of the ITAA 1997.

Furthermore, the amount is considered to have been derived in the year of receipt, which in your case is the year ended 30 June 2014. The fact that the payments may relate to an earlier year does not alter the outcome and the relevant legislation does not afford the Commissioner with a discretion to treat the amount as having a relationship to a different year of income.

As a result, the lumps sum of $XXX, XXX is considered to be assessable in full in the year ended 30 June 20XX.

Lump sum payments in arrears tax offset

Individual taxpayers who receive certain assessable lump sum payments containing an amount that accrued in earlier income years may be entitled to a lump sum in arrears tax offset under section 159ZRA of the Income Tax Assessment Act 1936 (ITAA 1936).

The tax offset is intended to overcome the problem of the lump sum attracting more tax in the year of receipt than would have been payable if the payment had been taxed in each of the years in which it accrued. The tax offset is broadly calculated as the difference between the extra amount of tax payable in the year of receipt because of the lump sum and the amount of tax that would have been payable if the lump sum had been taxed as it accrued.

Section 159ZRA of the ITAA 1936 allows a lump sum payments in arrears tax offset where the taxpayer's assessable income in a year of income includes one or more 'eligible lump sums'.

To be eligible for the tax offset, the amount of the eligible lump sum that accrued before the year of receipt must not be less than 10% of normal taxable income in the year of receipt less the arrears amount (paragraph 159ZRA(1)(b) of the ITAA 1936).

Normal taxable income is your taxable income less certain amounts as defined in subsection 159ZR(1) of the ITAA 1936.

Eligibility for tax offset

You meet the 10% eligibility test for the tax offset (section 159ZRA of the ITAA 1936).

Calculating the lump sum payments in arrears tax offset

Sections 159ZRB, 159ZRC and 159ZRD of the Income Tax Assessment Act 1936 set out the method for calculating the amount of the lump sum payment in arrears tax offset.

The lump sum payments in arrears tax offset is calculated by:

• Tax on arrears (determining the additional tax that you paid in the year the payment was received); subtracting

• Notional tax on arrears (the notional tax that would have been payable if the lump sum had been received in the years that the payment related to.)

The notional tax on arrears is made up of three elements. It includes:

• The additional tax that would have been payable in the most recent accrual year before the year of receipt,

• The additional tax that would have been payable in the second most recent accrual year before the year of receipt, and

• A notional tax amount for earlier income years that the payment related to. This is calculated by taking the average tax rate from the most recent two past accrual years and then applying this to the amount of the payment that relates to earlier tax years.

The definition of recent accrual year in relation to the total arrears amount means:

• if there are 3 or more accrual years for the total arrears amount - the most recent 2 of those years; or

• in any other case - the accrual year, or each of the accrual years, for the total arrears amount

This does not include the year of receipt of the lump sum arrears.

Application to your circumstances

In your case, you received lump sum payments in arrears of $XXX, XXX from back pay during the 20WW-XX year of income.

Based on the information you have provided, we have calculated that you are entitled to claim a lump sum payments in arrears tax offset of $XX,XXX in your assessment for the financial year ended 30 June 20XX.

Your lump sum payments in arrears tax offset has been calculated and an itemised list was provided for your information:

Even though the client may be eligible for the income tax offsets, there are two situations in which the tax offset will be nil:

• the lump sum amount that does not shift client's taxable income into a higher tax bracket, and

• the tax rate that would have attached to that part of the lump sum attributable to a prior year was higher.