Private ruling: tax treatment of invalidity pensions
Date of advice: 12 February 2018
Published: June 2018
Ruling period: Income year ended 30 June 2014; | Income year ended 30 June 2015; | Income year ended 30 June 2016; | Income year ended 30 June 2017; and | Income year ending 30 June 2018
Date scheme commenced: 1 July 2013

Ruling: Q1: Are the payments of the invalidity pension paid to a person (the Client) 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)? | A1: Yes. | Q2: If ‘yes’ to the previous question, are the payments of the invalidity pension paid to the Client excluded by section 307-10 of the ITAA 1997 from the definition of superannuation benefit in section 307-5 of the ITAA 1997? | A2: No. | Q3: 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 subregulation 995-1.01(1) of the Income Tax Assessment Regulations 1997 (ITAR 1997)? | A3: Yes. | Q4: Is the invalidity pension payable to the Client under the rules of the MSBS an employment termination payment under section 82-130 of the ITAA 1997? | A4: No. | Q5: Is the invalidity pension paid under the rules of the MSBS paid in respect of an interest that is a defined benefit interest under section 291-175 of the ITAA 1997? | A5: Yes. | Q6: Is the invalidity pension treated as exempt income under Part 2-15 of the ITAA 1997? | A6: No.

Relevant facts and circumstances: As a member of the Australian Defence Force (ADF), the Client 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 from the ADF 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 of the 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 of the 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 of the MSBS Rules). However, no invalidity pension is payable to a person whose incapacity for civil employment is classified as Class C (rule 31 of the MSBS Rules). In very simple terms, the ‘employer benefit’ is worked out having regard to the Client’s final average salary and their 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 periodic reviews of their level of incapacity for civil employment (rule 25 of the 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 of the MSBS Rules). However, once an individual reaches the age of 55 these classification rules change. From age 55, a Class A recipient cannot be reclassified, and a Class B recipient cannot be reclassified to Class C incapacity for civil employment (subrule 23(2) of the 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 Commonwealth Superannuation Corporation (CSC) to the Commonwealth and the invalidity pension is payable to the individual by the Commonwealth from the Consolidated Revenue Fund (section 13 of the 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 of the MSBA). The CSC is currently withholding amounts from the Client’s invalidity pension on the basis that each fortnightly payment of the pension is a superannuation income stream benefit that they are required to include in their assessable income. The Client did not make an election under regulation 995-1.03 of the ITAR 1997 to treat one or more of the payments they received from their invalidity pension before 1 July 2017 as a superannuation lump sum. The Client is under their preservation age. The Client’s pension commenced during the 2013-14 income year.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 11-15 | Income Tax Assessment Act 1997 section 55-5 | Income Tax Assessment Act 1997 subsection 55-5(1) | Income Tax Assessment Act 1997 paragraph 55-5(1)(c) | 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 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 Subdivision 307-B | 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 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 former regulation 995-1.03 | Superannuation Industry (Supervision) Act 1993 section 10 | Superannuation Industry (Supervision) Regulations 1994 subregulation 1.06(1)

Reasons for decision: Detailed Reasoning - Detailed reasoning: 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 the 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 DFRDB 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. | Detailed Reasoning - Question 2: If ‘yes’ to the previous question, are the payments of the invalidity pension paid to the Client excluded by section 307-10 of the ITAA 1997 from the definition of superannuation benefit in section 307-5 of the ITAA 1997? | Detailed Reasoning - Answer 2: No. | Detailed Reasoning - Detailed reasoning: 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 grounds 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 (by more than 30%) 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. | Detailed Reasoning - 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 subregulation 995-1.01(1) of the Income Tax Assessment Regulations 1997 (ITAR 1997)? | Detailed Reasoning - Answer 3: Yes. | Detailed Reasoning - Detailed reasoning: 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 former regulation 995-1.03 of the ITAR 1997 applied where the payment was made before 1 July 2017) (subsections 307-70(1) and (2) of the ITAA 1997 and subregulation 995-1.01(2) of the ITAR 1997). A definition of ‘superannuation income stream’ is set out in subregulation 995-1.01(1) of the ITAR 1997. On the issue of whether MSBS invalidity 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 SISA in accordance with subregulation 1.06(1) of the Superannuation Industry (Supervision) Regulations 1994 (SISR). The expression ‘income stream’ is not defined by either the income tax or superannuation laws. Therefore, 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 you point to the conditions in former regulation 995-1.03 of the ITAR 1997 in order to conclude that the invalidity pension is not a superannuation income stream. However, we note that regulation could only affect whether a particular payment from a superannuation income stream was a superannuation income stream benefit or a superannuation lump sum. It had no effect on whether a person’s benefits paid from their superannuation fund were a superannuation income stream or not. Former regulation 995-1.03 only applied if a member’s benefits were being paid as a superannuation income stream as defined. | Detailed Reasoning - Question 4: Is the invalidity pension payable to the Client under the rules of the MSBS an employment termination payment under section 82-130 of the ITAA 1997? | Detailed Reasoning - Answer 4: No. | Detailed Reasoning - Detailed reasoning: Under section 82-130 of the ITAA 1997, a payment is an employment termination payment if each of the following three conditions are 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 the ITAA 1997 (paragraph 82-130(1)(c)). Even in the event it could be said that payments made from the MSBS invalidity pension meet the conditions set out paragraphs 82-130(1)(a) and (b) of the ITAA 1997, 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, the Client’s 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 (whether or not the payment is a superannuation benefit) 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 the Client 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. | Detailed Reasoning - Question 5: Is the invalidity benefit paid under the rules of the MSBS paid in respect of an interest that is a defined benefit interest under section 291-175 of the ITAA 1997? | Detailed Reasoning - Answer 5: Yes. | Detailed Reasoning - Detailed reasoning: 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; … (d) specified conversion factors. However, subsection 291-175(2) of the ITAA 1997 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) of the ITAA 1997. 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 291-175(2) of the ITAA 1997 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) of the ITAA 1997 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 MSBS. 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 the 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. | Detailed Reasoning - Question 6: Is the invalidity pension treated as exempt income under Part 2-15 of the ITAA 1997? | Detailed Reasoning - Answer 6: No. | Detailed Reasoning - Detailed reasoning: Section 11-15 of the ITAA 1997 lists provisions that deal with types of ordinary or statutory income which are exempt income for the purposes of both the ITAA 1997 and Income Tax Assessment Act 1936 (ITAA 1936). The list refers to certain payments and allowances paid to Defence Force members which are made exempt by section 51-5 of the ITAA 1997. It also refers to pay and allowances paid to Defence Force members for being on eligible duty which are made exempt by section 23AD of the ITAA 1936. Although there is a range of payments in respect of Defence Force members that are exempt income, such payments do not include invalidity pension payments received from the MSBS. Division 55 of the ITAA 1997 is designed to reduce confusion as to what payments are exempt from income tax. It identifies payments that are not exempt from income tax even though they are similar in nature to payments that are wholly or partly exempt under other provisions of Part 2-15 of the ITAA 1997 (which deals with non-assessable income). Subsection 55-5(1) of the ITAA 1997 provides that Part 2-15 does not exempt from income tax any amount paid under the following provisions or Acts, or under schemes established under any of them: (a) Defence Force Retirement and Death Benefits Act 1973 ; (b) Defence Forces Retirement Benefits Act 1948 ; (c) Military Superannuation and Benefits Act 1991; (d) … The invalidity payments the Client has received, and will continue to receive, are being paid under the rules of the MSBS, established by trust deed under the MSBA. Therefore, due to paragraph 55-5(1)(c) of the ITAA 1997, we consider that the amount paid to the Client under the MSBS is not exempt income under Part 2-15 of the ITAA 1997. Further, there is no other provision in the ITAA 1997 or the ITAA 1936 under which the invalidity payments the Client receive are treated as exempt income.

Are the payments of the invalidity pension paid to the Client 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)?