Invalidity benefits paid through Defence Force superannuation schemes are generally taxed at a higher rate than invalidity benefits paid through civilian superannuation insurance schemes.
What are Defence Force Superannuation Invalidity Benefits?
Veterans who were medically discharged, or should have been medically discharged, may be entitled to receive invalidity benefits through the Defence Force superannuation scheme they contributed to, or were covered by, while they served.
The condition that caused the medical discharge, or should have caused it, does not need to have been related to service to receive an invalidity benefit. For instance, a veteran may have been medically discharged due to injuries sustained during a leave period. A veteran may be entitled to superannuation invalidity benefits, but not entitled to military compensation administered by DVA.
The superannuation scheme will depend on when the veteran joined the Defence Force, and whether they elected to change to a newer scheme, if they were given the opportunity to do so. Those schemes are:
- Defence Force Retirement Benefits (DFRB). Open from 1948 to 30 September 1972.
- Defence Force Retirement and Death Benefits (DFRDB). Open from 01 October 1972 to 30 September 1991.
- Military Superannuation and Benefits Scheme (MSBS). Open from 01 October 1991 to 30 June 2016.
- Australian Defence Force Cover (ADF Cover). Provides consistent superannuation invalidity benefit coverage to ADF members, enabling member choice of superannuation fund. Open from 1 July 2016.
Under each scheme, medically discharged veterans are classified according to their level of incapacity for civilian employment:
- Class A – incapacity of 60% or more.
- Class B – incapacity of 30% or more, but less than 60%.
- Class C – incapacity of less than 30%.
Veterans with a Class A or B invalidity will receive a benefit paid as a pension. The amount of pension varies between schemes and is based on several factors such as the class of invalidity, age, length of effective service, and final salary or final average salary. Generally, a Class B pension is 50% of a Class A pension.
Invalidity benefits may be reviewed up to age 55. This means, for example, that a veteran receiving a Class A pension, may have it reduced to a Class B pension or to no pension at all. It is also possible that a veteran may receive an increase from a Class B to Class A pension.
Taxation
The Commonwealth Superannuation Corporation (CSC), which administers the four schemes, decided that invalidity pensions paid under the schemes were superannuation income stream benefits and has historically reported the payments as such to the Australian Taxation Office (ATO). This means that the taxable component of the pension has been taxed at the veteran’s marginal tax rate.
The Superannuation Industry (Supervision) Regulations 1994 (Cth) defines the criteria that determines the nature payments. DFRDB and MSBS invalidity benefits do not meet the criteria necessary to be classified as a superannuation income stream benefit, primarily because they are not lifetime pensions. Invalidity benefits are not guaranteed to be paid throughout the lifetime of the Veteran because under DFRDB and MSBS rules the benefit can be varied or ceased due to a review and other factors.
Under the legislation, if it does not meet the criteria of a superannuation income stream benefit, by default, payments received are to be treated and taxed as lump sum payments.
So What is Happening?
Three veterans challenged the superannuation income stream benefit classification of their invalidity benefits, paid under DFRDB and MSBS, through requests for reasons, taxation private rulings, objections and through the administrative appeals tribunal.
Given the significance of the cases, the ATO granted test case litigation funding, in order to completely deal with the issues in question – and arrive at a binding decision.
On 4 December 2020, the full bench of the Federal Court of Australia handed down its decision in the three cases. The cases are collectively known as the Douglas Case.
The outcome of their cases had mixed results:
- DFRDB and MSBS Invalidity Benefits that commenced on or after 20 September 2007 – payments are treated as superannuation lump sum payments.
- DFRDB and MSBS Invalidity Benefits that commenced before 20 September 2007 – payments continue to be treated as superannuation income stream payments.
Many veterans whose invalidity benefits are treated as superannuation lump sum payments may be able to have their pension considered disability superannuation benefits which results in significant savings. Read more about disability superannuation benefits here
While most veterans are better off following the Douglas decision, there are some who are negatively affected.
DFWA has maintained an active interest in these cases and has supported the veterans where possible. The Queensland Branch Honorary Legal Advisory Firm, Cleary Hoare Solicitors, has been heavily involved, representing the veterans who are the test cases.
DFWA will provide updates as and when they occur.
Updates
Proposed Legislation Reversing the Decision in Douglas v Commissioner of Taxation
Invalidity Benefits Taxation – Questions Put to the Commonwealth Superannuation Corporation
Update on DFRDB and MSBS Invalidity Benefits Taxation – ATO Streamlined Process
Update on DFRDB and MSBS Invalidity Benefits Taxation Changes
Update on DFRDB and MSBS Invalidity Benefits Taxation Case
Update on DFRDB and MSBS Invalidity Benefits Taxation Case
No Appeals in Veteran Invalidity Benefit Taxation Cases
Federal Court Decision – Taxation of Invalidity Benefits
Taxation of CSC Invalidity Benefits
In March 2020, the Administrative Appeals Tribunal (AAT) in Brisbane upheld the objections of the three Veterans against the Australian Tax Office (ATO) treatment of their DFRDB and MSBS Class A and B Invalidity Benefits paid by the Commonwealth Superannuation Corporation (CSC). This effectively meant that the Invalidity Benefits paid by CSC should be treated as lump sum payment and not as superannuation income stream benefit, i.e., less tax to be paid. In handing down…