What are the tax-free parts of employment termination payments?

Certain portions of employment termination payments are tax-free. These include what are known as the “invalidity segment” of such payments, ie. where the person has stopped being gainfully employed because he or she suffered from physical or mental ill-health.

These situations crop up regularly throughout the workforce, although the tax ramifications and implications are often not well understood.

A recent case before the Administrative Appeals Tribunal (AAT) – AAT Case [2010] AATA 843, Re Sills and FCT – highlighted the issues involved here and may help with understanding how the effective tax exemption works.

The AAT held that two employment termination payments (ETPs) received by a former NSW police officer qualified as invalidity payments (and were therefore tax-free) after ruling that the two medical certificates supplied by the taxpayer satisfied the requirements under the tax law.

The taxpayer was a police officer from 1996 until 2007 when he was medically discharged from the NSW Police Force after suffering a back injury in 2005. After his injury, and prior to his medical discharge, he worked on restricted duties as an assistant station manager. Shortly after leaving the Police Force, the taxpayer was employed as a development compliance officer with a local council where he has remained employed.

The man received two lump sum payments in relation to his termination of employment from the Police Force, one of $136,632 and second of $336,116. He claimed that the ETPs included tax-free invalidity segments.

The invalidity test in the tax law requires that two legally qualified medical practitioners must have certified that, because of ill health, it is unlikely the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, training or experience. The taxpayer supplied two medical certificates.

The Tax Commissioner considered that the two medical certificates did not satisfy the requirements under the tax law. The Commissioner argued that the medical certificates did not properly address the capacity of the former police officer to be employed, his qualifications, training and other relevant factors which the Commissioner claimed were mandatory considerations.

The Commissioner also submitted that the medical certificates did not mention the man’s current job as a compliance officer with a local council and the duties associated with it. Rather, the Commissioner argued that the medical certificates had simply repeated the words of the legislation.

The AAT disagreed and set aside the Commissioner’s decision and ruled that the two ETPs included a tax-free invalidity segment under the law.

The AAT considered that the medical certificates, on their face, properly answered the questions posed by the legislation. One of the medical certificates stated:

“As a result of his injuries he was medically discharged from the Police Force and at present he is working on a full-time basis at Lake Macquarie Council, avoiding aggravating activities.

He used to work as a Shop Fitter & Joiner prior to joining the Police Force and as a result of his injuries in the Police Force he was medically discharged.

I believe the disability suffered by Mr Sills resulted in him being unable to ever be employed in a capacity for which he is reasonably qualified by reasons of education, training or experience.”

The other medical certificate said, in part:

“He is therefore permanently unfit to return to his occupation as a police officer, which is likely to aggravate his condition.

Since Mr Sills was suffering from his condition at the time of his medical discharge, he would be unable to ever be employed in a capacity for which he was, at the time of his medical discharge, reasonably qualified because of education, training or experience.”

The AAT found that the taxpayer’s education, experience and training, first as a labourer and shop fitter, then as a police officer, were in the written documents before the doctors (and the AAT). As a result, the AAT was satisfied the doctors had addressed the relevant issues in their medical certificates and the requirements of the relevant law were satisfied. In this respect, the AAT said the certification under the relevant provisions of the tax law rested with the medical practitioners, and not the Tax Commissioner (or the AAT).

In addition, the AAT rejected the Commissioner’s argument that the relevant legislation imposed an additional requirement that each medical certificate must set out the evidence on which the doctor’s opinion is based.

Accordingly, the AAT held that the amounts received by the man were ETPs and included a tax-free invalidity segment.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .