Private ruling: tax treatment of invalidity pensions
Date of advice: 10 November 2016
Published: December 2016
Ruling period: Income year ending 30 June 2017 | Income year ending 30 June 2016 | Income year ending 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Does an invalidity pension paid under the rules of the Superannuation Fund (the Fund) established by a trust deed (the Fund Act) constitute a superannuation income stream as that terms is defined in section 307-70 of the Income Tax Assessment Act 1997 (ITAA 1997) and regulation 995-1.01(1) of the Income Tax Assessment Regulations 1997 (ITAR)? | A1: Yes | Q2: 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? | A2: Yes | Q3: If yes to the previous question, is the formula in section 307-145 of the ITAA 1997 applicable to the superannuation lump sum benefit if it is also considered a disability superannuation benefit? | A3: Yes

Relevant facts and circumstances: As a member of the Australian Defence Force (ADF), you became a member of the Fund. The Fund is a scheme which was established to provide benefits that are payable when an individual retires from the ADF. Amongst other things, the rules of the Fund (the Fund 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 Fund 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 Fund Rules). Under that rule, an individual is assessed as having a Class A, Class B or Class C incapacity for civil employment. The Fund 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 Fund 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 the amount payable to a Class A recipient (rule 28 of the Fund Rules). However, no invalidity pension is payable to a person whose incapacity for civil employment is classified as Class C (rule 31 of the Fund 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 Fund 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 Fund 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 Fund Rules require an individual to undergo periodical reviews of their level of incapacity for civil employment (rule 25 of the Fund Rules). The Fund 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 Fund Rules). However, an individual who has reached the age of 55, cannot be reclassified to Class C incapacity for civil employment (subrule 23(2) of the Fund Rules). Upon becoming entitled to receive an invalidity pension from the Fund, an amount equal to the funded employer benefit is paid by the Commonwealth Superannuation Scheme (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 Fund Act). If an invalidity pension that was payable to an individual who was classified as having a Class A or Class B invalidity 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 Fund Act). 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 required to include in your assessable income. In your application for this private ruling you have contended that: ● The invalidity payments is subject to regular medical reviews which can result in a higher or lower payment or a cancellation of the benefit altogether. This means the payment is variable outside the terms and guidelines as stated in regulation 995-1.03 of the ITAR 1997. This means the recipient is able to elect to have the invalidity benefit taxed as a lump sum and not treated as a ‘superannuation income stream benefit’. ● You believe you can make the election as per regulation 995-1.03 of the ITAR 1997 as your payment is variable outside the terms as set out; and ● You believe that in making this election, the applicable formula to use is contained in section 307-145 of the ITAA 1997 provided that you supply two doctors’ reports as per the definition of ‘disability superannuation benefits’.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subdivision 307-B | Income Tax Assessment Act 1997 section 307-70 | Income Tax Assessment Act 1997 section 307-145 | 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 | Superannuation Industry (Supervision) Act 1993 section 10 | Superannuation Industry (Supervision) Regulations 1994 subregulation 1.06(1)

Reasons for decision: 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 regulation 995-1.03 of the ITAR 1997 applies (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 these Fund 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 Superannuation Industry (Supervision) Act 1993 (SISA) in accordance with subregulation 1.06(1) of the Superannuation Industry (Supervision) Regulations 1997 (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 payment that relate to each other and that are payable over an identifiable period of time. The invalidity pension payable by the Fund amounts to such as series of fortnightly payments. Having examined the terms under which the invalidity pension is payable by the Fund and under the Fund Act, we are satisfied that the invalidity pension is a pension that meets the requirements set out in subregulation 1.06(1) of the SISR. | Detailed Reasoning - Question 2: If ‘yes’ to the previous question, can you make the election in regulation 995-1.03 of the ITAR 1997 before a particular payment of the invalidity pension is made, that the payment is not to be treated as a superannuation income stream benefit? | Detailed Reasoning - Answer: Yes | Detailed Reasoning - Detailed reasoning: Regulation 995-1.03 of the ITAR 1997 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 1997 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 subparagraphs(a)(i) to (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 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 of the Fund Rules permits a person who has been classified under Rule 22 of the Fund Rules 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 the Fund 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 Class A invalidity pension. We consider that in the circumstance where the annual amount of payments from the Fund invalidity pension is altered in response to the application of Rule 23 of the Fund Rules, this reflects a circumstance other than the one set out in subparagraphs 995.1.03(a)(i) to (iv). Accordingly a person in receipt of the Fund invalidity pension may make an election under regulation 995-1.03 of the ITAR 1997 in respect of a payment provided they make the election before the payment from their pension is made. This election needs to be made to the superannuation fund that is making the superannuation payments, in your case the CSC. | Detailed Reasoning - Question 3: If ‘yes’ to the previous question, is the formula in section 307-145 of the ITAA 1997 applicable to the superannuation lump sum benefit if it is also considered a disability superannuation benefit? | Detailed Reasoning - Answer: Yes | Detailed Reasoning - Detailed reasoning: A superannuation benefit that is also a ‘disability superannuation benefit’ as defined in subsection 995-1(1) of the ITAA 1997 will typically be taxed less than an ordinary superannuation benefit. A disability superannuation benefit is defined under subsection 995-1(1) if the ITAA 1997 as follows: disability superannuation benefit means a *superannuation benefit if: (a) the benefit is paid to a person because he or she suffers from ill-health (whether physical or mental); and (b) 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 a capacity for which he or she is reasonably qualified because of education, experience or training. *To find the definition of asterisked terms, see the Dictionary, starting at section 995-1. | Detailed Reasoning - Tax treatment of the invalidity pension payments that are superannuation lump sums: Where you provide your fund with an election, under 995-1.03 of the ITAR 1997 before a particular pension payment is received, it will be treated as a superannuation lump sum benefit. If the superannuation lump sum benefit also satisfies the definition of a disability superannuation benefit, section 307-145 of the ITAA 1997 will apply to effectively increase the tax-free component of the lump sum in accordance with the following formula: Amount of benefit × The formula takes into account the length of your service and the days until you would normally have been expected to retire. If you have the relevant documentary evidence from two legally qualified medical practitioners, you should provide it to your fund so they can apply the formula to any superannuation lump sum benefits you receive.

Question 1: Does an invalidity pension paid under the rules of a superannuation fund (the Fund) established by a trust deed under a law of the Commonwealth (the Fund Act) 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 ITAR 1997?