Income tax: are amounts mistakenly paid as salary or wages to employees (or as income support payments or worker's compensation amounts to persons), to which they are not beneficially entitled, but are obliged to repay, 'ordinary income' under section 6-5 of the Income Tax Assessment Act 1997?

No. Amounts mistakenly paid as salary or wages to employees, (or as income support payments [1] or worker's compensation amounts to persons), to which they are not beneficially entitled, but are obliged to repay, are not derived by these persons as income according to ordinary concepts. Accordingly, such mistakenly paid amounts are not assessable income of these persons under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). [2]

Taylor works as a public servant in a government department. Taylor is paid her salary on a fortnightly basis by direct credit into her bank account. During the 2006-07 income year Taylor temporarily performed duties at a higher pay scale level. A subsequent review of higher duty payments made to Taylor was undertaken by the department's personnel section. The review established that Taylor had, due to an administrative error, been mistakenly paid three amounts of $500 to which she was not entitled. That is, a total amount of $1,500 was paid to Taylor in error during the period that she performed duties at the higher pay scale. The circumstances are such that Taylor has an obligation to repay the three amounts paid by mistake. The mistakenly paid amount of $1,500 was a gross amount from which tax was withheld.

The amount of $1,500 is not ordinary income of Taylor during the 2006-07 income year, as she was not beneficially entitled to that amount.

Hannah is in regular receipt of a social security payment. A review of her circumstances established that she had, in error, been mistakenly paid amounts totalling $825 during the 2006-07 income year to which she was not entitled. The error was due to Hannah making an incorrect income declaration. The circumstances are such that Hannah has an obligation to repay the amounts paid by mistake.

The amount of $825 is not ordinary income of Hannah during the 2006-07 income year, as she was not beneficially entitled to that amount.

Mike is a member of the Australian Defence Force (ADF) and during the 2005-06 income year was paid a retention bonus to encourage him to serve an agreed period in the ADF. The bonus was paid as a lump sum, and was required to be repaid on a pro-rata basis if he resigned before the end of the retention period. Mike resigned from the ADF during the 2006-07 income year (before the end of the retention period ). The full amount of the retention bonus that Mike received is ordinary income in the income year in which he received it. He was beneficially entitled to that amount according to the terms and conditions of the retention agreement and the amount otherwise had the character of ordinary income.

However, pursuant to section 59-30, the amount of the retention bonus that Mike must and does repay in a later year is thereafter, not assessable income and is not exempt income.

This Determination applies to years of income commencing both before and after its date of issue. However, the Determination does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10).

Amounts paid to a taxpayer will be assessable income if they are income according to ordinary concepts (ordinary income) under section 6-5 or statutory income within the meaning of section 6-10. [3]

For an amount to be income according to ordinary concepts it must be income derived by the taxpayer. The proposition that a taxpayer will not derive ordinary income unless they are beneficially entitled to the amount has longstanding judicial support.

In The Countess of Bective v. Federal Commissioner of Taxation (1932) 47 CLR 417; [1932] HCA 22 amounts paid to the taxpayer by the trustee of a trust fund, for the purpose of the maintenance and support of the taxpayer's daughter, were held not to be assessable income of the taxpayer. Dixon J said at 424: ...if she is not an object intended to be benefited at all by the provision for maintenance, the payments ought not, in my opinion, to be included as assessable income of the taxpayer...

In Zobory v. Commissioner of Taxation (1995) 64 FCR 86; 95 ATC 4251; (1995) 30 ATR 412 ( Zobory ), interest earned on funds misappropriated by the taxpayer from his employer was held not to be assessable income of the taxpayer. Burchett J concluded that the funds were held on constructive trust for the taxpayer's employer and the interest was not income derived by the taxpayer. Burchett J held at FCR 89; ATC 4253; ATR 414 that: The fundamental principle which must be the starting point for a consideration of this case is the rule that the general provisions of the Income Tax Assessment Act 1936 are directed to income to which a taxpayer is beneficially entitled.

Whether payments of certain worker's compensation amounts, to which the taxpayer was not legally entitled, were income derived by the taxpayer within the meaning of subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936) was considered in Reiter v. Commissioner of Taxation (2001) 113 FCR 492; 2001 ATC 4502; (2001) 47 ATR 533 ( Reiter ). The taxpayer challenged the Commissioner's position on derivation of payments where amounts were subsequently repaid. The Federal Court ruled in favour of the taxpayer on the basis that the payer, Workcover Corporation, had no legal obligation to pay the taxpayer fortnightly instalments of worker's compensation, nor was the taxpayer beneficially entitled to receive the amount. Therefore, the amounts were not derived for the purposes of subsection 25(1) of the ITAA 1936. Branson J cited the decision in Zobory and said at FCR 499; ATC 4507; ATR 539 that: In my view, the applicant was not beneficially entitled to such of the amount of $16,773 as was paid to him by the Corporation after the expiration of the stay of execution of the judgment of the Supreme Court of Victoria (the post-bar amount). The Corporation had no legal entitlement to pay him the post-bar amount by reason of the operation of subs 55(3) of the WRC Act. Conversely, the applicant had no legal entitlement to receive the post-bar amount. The respondent acknowledged that the Corporation had a statutory right of recovery in respect of the post-bar amount. The post-bar amount was not, in my view, in these circumstances income derived by the applicant within the meaning of subs 25(1) of the ITAA.

The decisions in these cases demonstrate that a taxpayer must be beneficially entitled to an amount for the amount to be derived by the taxpayer as ordinary income. Reiter illustrates the application of this proposition in a situation where the taxpayer's lack of beneficial entitlement coincided with the taxpayer not being legally entitled to the amounts they had received. It was not a case where the court found that the taxpayer had in any sense become a trustee in relation to these amounts (at FCR 499; ATC 4508; ATR 539-540).

Amounts mistakenly paid as salary or wages to employees (or as income support payments or worker's compensation amounts to persons), to which they are not beneficially entitled, but are obliged to repay, are not derived by these persons as ordinary income. Accordingly, such mistakenly paid amounts are not assessable income of these persons under section 6-5.

However, if the person's obligation to repay the mistakenly paid amount is subsequently waived, then there may be income tax or fringe benefits tax ramifications. For example, where the payer is the person's employer, a debt waiver fringe benefit may arise: refer to Taxation Determination TD 2008/11. If the payer is not the person's employer, but there is a possibility the gain derived from waiving the debt occurs in some way as a reward for the person's services, or as a supplement of some sort to their income earning position, [4] it may be advisable to apply for a private ruling about whether the gain is assessable income.