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6.3.25 Taxation Arrangements for Incapacity Payments
Incapacity payments are made as economic loss compensation by way of income replacement, as distinct from non-economic loss compensation such as for permanent impairment. Incapacity payments are generally linked to a person's pre-injury earnings and are taxable at the appropriate marginal tax rate prior to payment to the person. Instructions as noted on a person's Tax Declaration form must be followed.
Incapacity payments are generally taxable because they are income-related payments. However, where the earnings being replaced are non-taxable, so too are the incapacity payments.
The following types of incapacity payments are exempt from taxation by virtue of sections 51-32 and 51-33 of Income Tax Assessment Act 1997:
- Payments for the loss of pay and allowances while on a period of warlike service;
- Payment for the loss of allowances while on a period of non-warlike service; and
- Payment for the loss of pay or allowances as a part time Reservist.
Schedule 4 of the Military Rehabilitation and Compensation (Consequential and Transitional Provisions) Act 2004 (CTPA) provides that incapacity payments made in respect of lost Reserve earnings, lost pay and allowances while on warlike service, or lost allowances while on non-warlike service are tax free.
However if a person's NE is calculated by reference to:
- the national minimum wage; or
- seven times a person's daily rate of Reserve pay;
then those incapacity payments are assessable for income tax purposes.
Additionally the component of NE attributable to a Reservist's civilian earnings is assessable for income tax purposes.
220.127.116.11 Warlike and non-warlike service
Generally all pay and allowances are tax-free while a member is deployed on warlike service. As incapacity payments retain the same nature of the payments they are compensating, incapacity payments for the loss of pay and allowances while on a period of warlike service are tax-free.
Generally for non-warlike service only allowances are tax-free. Therefore any incapacity payments for loss of deployment or other allowances during a period of non-warlike service are also tax-free.
The tax-free nature of incapacity payments only continues for the loss of pay or allowances during the period of the warlike or non-warlike service. Thereafter any incapacity payments are taxable.
Delegates should access the Service Eligibility Assistant in the CLIK legislation library to assist with verification of warlike or non-warlike service. These determinations are made for either the VEA or MRCA and can assist in the identification of the type of service and which allowances might apply.
18.104.22.168 Reserve earnings
Weekly incapacity benefits paid for loss of part-time Reserve income are not considered to be taxable income because they are considered to retain the original nature of the salary payment. In other words, Reserve earnings are not taxable so compensation for loss of ability to earn in the Reserve is also considered not to be taxable.
While Reserves payments (earnings) are tax-free. All other earnings, i.e. earnings from civilian employment, are subject to tax. However there is only one NE. Both civilian and Reserves earnings combined, form a single amount, only part of which is taxable. The incapacity calculator identifies what portion of any compensation paid is taxable and non-taxable.
Where NE is deemed using the ‘daily Reserve rate x 7’ or the national minimum wage, all of the weekly compensation payment is taxable.
Where a Reservist is injured during a period of full-time service and their NE is based on their full-time ADF rate of pay, then incapacity payments are taxable.
22.214.171.124 Lump sum arrears of incapacity payments and recovery of Centrelink and or VEA pensions
Some arrears of incapacity payments will involve recoveries in respect of pensions paid by Centrelink under the Social Security Act 1991 (SSA) or under the Veterans' Entitlements Act 1986 (VEA).
For arrears payments involving recovery of a VEA pension, taxation is applied before the amount of VEA pension is deducted. However, where the incapacity payment is tax exempt then no taxation is applied to the gross amount. Delegates should note that this is based on new advice from the ATO and should only be applied to incapacity payments made after 1 July 2010.
For arrears payments involving recovery of a Centrelink pension, taxation is also applied before the amount of pension is deducted.
Incapacity delegates should follow the existing procedures for Centrelink recoveries in PMKeyS, but use deduction code RM3500 for the amount of any VEA recovery.
Where there is insufficient funds , after taxation is withheld, the amount of VEA recovery should be processed first. The remainder should be allocated to the Centrelink recovery, with any outstanding debt, being a debt to Centrelink for Centrelink to recover.
A person is entitled to arrears of incapacity of $85,000. However that person has already received $20,000 from Centrelink and $15,000 under the VEA.
The whole amount of $85,000 is subject to PAYG Withholding. The arrears relates to entitlements over three financial years. The amount taxation calculated using MYSTIC is $16,000. Therefore the payment is processed as follows:
Gross Amount $85,000
Less Tax to be withheld $16,000
Less VEA recovery $15,000
Less Centrelink recovery $20,000
Net arrears payment $34,000
Lump sum redemptions are also taxable. However for more detail see 6.4.2 which provides further commentary on redemption of small amounts of weekly compensation.