On 4 December 2020, the Full Court of the Federal Court delivered judgement in Commissioner of Taxation v Douglas  FCAFC (hereby referred to as ‘Douglas’), that altered the way invalidity pension payments under the Defence Force Retirement and Death Benefits Scheme (‘DFRDB Scheme’) and the Military Superannuation and Benefits Scheme (‘MSB Scheme’) were taxed.
The case concerned whether certain invalidity benefits paid from pensions to individuals under the DFRDB and MSBS Schemes were classified as income stream benefits or superannuation lump sum payments, relevance of which is had to the respective tax implications of each payment classification.
For a payment to be classified as a superannuation income stream benefit, per subregulation 1.06(2) of the Superannuation Industry (Supervision) Regulations 1994 (SISR), the pension must be paid at least annually throughout the life of a primary or reversionary beneficiary, and the size of payments of a benefit in a year must be fixed, allowing for variation only as specified in the governing rules. In their decision, the Federal Court found that the MSBS and DFRDB Schemes do not satisfy the pension standards in the SISR, as the schemes accommodate reviews of a pensioners invalidity classification, thus making it possible for a pension to be cancelled as a result of reclassification, or for the size of a pension payment to be varied as a result of reclassification.
Accordingly, the Court found that invalidity benefits paid under pensions provided under the MSB or DFRDB Scheme that commenced on or after 20 September 2007 are superannuation lump sum benefits. Invalidity benefits paid under pensions provided under the MSB or DFRDB Scheme that commences before 20 September 2007 are superannuation income stream benefits.
The effect of the decision in Douglas is that many individual’s invalidity pension payments have been taxed as though they are superannuation income stream benefits, where they should have been taxed as superannuation lump sum benefits.
Consequently, if you received an invalidity pension provided under either DFRDB or MSB Schemes starting on or after 20 September 2007, you may be entitled to have a tax-free component applied against your past and future income tax returns dating back to the year you were medically discharged.
You can determine if you are eligible using the steps below:
Step 1: Were you discharged on or after 20 September 2007?
- If YES, you are affected
- If NO, go to step 2.
Step 2: Did your invalidity pension start on or after 20 September 2007?
- If YES, you are affected
- If NO, you are not affected
We note that there may be time between when you were discharged and when your payment commenced.
For example, you may have been discharged 31 March 2002 however only started receiving a payment under MSB or DFRDB Scheme as a result of a reclassification from Class C to A or B. In this case, if your reclassification from Class C to A or B took place after 20 September 2007, you will be affected by this decision.
Alternatively, you may have been retrospectively discharged on medical grounds years after your initial discharge. In this case, if you received notice about this retrospective discharge and were subsequently classified as Class A or B invalidity after 20 September 2007, you will be affected by this decision.
In each case, you should have received a letter stating your classification as Class A or B invalidity. If this letter is dated after 20 September 2007, it is likely you have been affected by this decision.
If you believe you have been affected, you will first need to apply to Commonwealth Superannuation Corporation (CSC) for a determination that your payments are classified as ‘Disability Superannuation Benefits’ (‘DSB’).
As per the Income Tax Assessment Act 1997 (Cth) (ITAA), for CSC to be able to make this determination, you must provide them medical certificates from two qualified practitioners that certify that because of ill health, you have been unable to be gainfully employed in a field for which you have training, education or experience since the date you were medically discharged.
This requirement is explicitly stated in the ITAA. For the avoidance of doubt, we encourage you to instruct your practitioners to use the above wording and to not neglect to state the effective date of your incapacity as the date of your discharge. We stress that if you have provided certificates that do not state the effective date of incapacity as the date of your discharge, CSC will date your DSB Determination from the date of the latest medical certificate.
CSC has advised that once these certificates have been provided, it will take between 8 to 12 weeks for CSC to make their determination. Once this determination has been made, CSC will report this regularly to the Australian Taxation Office (ATO) so they may commence automatic amendments of your past returns if you have opted-in to the streamlined amendment process. If you have not opted-in to the streamlined amendment process, these amendments can be made by lodging objections to your past returns after you have received your DSB determination from CSC.
We do note that just because you are affected does not mean amendments to your past income tax returns would result in a credit to you. The impact of this decision will depend on your individual circumstances, and amending your past income tax returns may, on your circumstances, result in a debit to the ATO. Where amendments have been made as a result of the lodgement of objections to a past income tax return, the ATO has advised us as to whether the objection is likely to result in a credit or debit, however we cannot guarantee this will always be the case.
Although we cannot predict the outcome of this process for you, we can calculate the tax free component you are likely entitled to based off your date of discharge, date of birth and date of enlistment. This percentage should then be applied against your returns from the date of your discharge to effectively lower your taxable income and thus the tax payable of your income.
Streamlined Amendment Process
If you are affected, the streamlined amendment process was introduced to make it easier for you to amend previous years’ income tax assessments. If you opted-in to the streamlined amendment process by writing to the ATO before 31 May 2021, you do not need to seek an amendment, private ruling or lodge an objection for the 2010-11 to 2019-20 income years. If you received a payment between 2007-08 to 2009-10 that should be amended, you will still need to lodge an objection through the proper channels along with a written request for an extension of time as the tax periods you are objecting to are outside the period of review.
Phase 1: For those who opted-in to the streamlined amendment process, the ATO should have already reviewed and processed your amendments. If your circumstances are more complex, the ATO may still be in the process of reviewing and amended your past returns in accordance with your revised tax treatment as a superannuation lump sum.
Phase 2: For those who did not opt-in, however have been deemed by the ATO to be eligible for the revised tax treatment under Douglas, the ATO will be contacting you regarding potential amendments.
If you believe you are eligible but have missed the deadline for opting-in to the streamline amendment process or have not been contacted by the ATO about potential amendments, you can still seek a review of your assessments by completing a ‘Request for objection – for recipients of certain invalidity benefits form’ provided by the ATO.
Prior to lodging any objections, you must ensure you have received your DSB determination and have lodged any overdue tax returns. If you have not ensured you have received your DSB determination, objecting to a return may result in a debit to ATO. If you have not lodged all overdue tax returns, ATO will not be able to process your objection.
If you are affected by Douglas, it is possible that the ATO have taxed your payments at a much higher rate than they should have. Although we cannot anticipate the figure amount of any possible tax refund, we can calculate the tax-free component percentage that should be applied against your past and future returns to alter your taxable income.
We note that your particular circumstances are vital when determining whether objecting to past returns will put you in a more favourable position. The alteration of your taxable income can have effects on other payments and obligations such as:
- Family Tax Benefits
- Child Care Subsidy
- Paid Parental leave payments
- Child support payments
- Other government support payments that take into account your taxable income.