Three former Australian soldiers are fighting the Australian Tax Office (ATO) for taking tax out of their medical discharge benefits.

Key points: The ATO is taxing the medical benefit payments of veterans

The ATO is taxing the medical benefit payments of veterans Three veterans are now challenging the ATO in court

Three veterans are now challenging the ATO in court The Government changed "income stream" regulations during the case

"It's 100 per cent clear that the ATO has done the wrong thing by these veterans," their lawyer Daniel Paratore, himself a veteran, told 7.30.

"They're not seeking a handout. But to think that when they do get that helping hand, almost all of it is taxed — that's an act of bastardry."

Veterans damaged then taxed

Wayne Douglas was in the Army for more than 25 years. ( Supplied: Wayne Douglas )

Wayne Douglas is one of the three veterans who are now party to a test case before the Administrative Appeals Tribunal (AAT).

He lost more than two thirds of his $370,000 medical benefit when he received it as a lump sum.

Mr Douglas is a former military intelligence specialist who joined the Army in 1976.

His post-traumatic stress disorder (PTSD) began when he served in a UN-backed intervention in Somalia in the 1990s, chasing war criminals and getting caught in ambushes.

At one stage he and his translator were surrounded. Alone in a room with dozens of gunmen he thought he was going to die.

"That put a crack in my confidence," he told 7.30.

"That … crack remained there and never went away. After the incident, for two or three weeks after, I don't remember much at all."

He retired in 2002 with serious physical injuries and mental health concerns.

Unable to hold down a civilian job, the Australian Defence Force (ADF) recognised his medical discharge and backdated it in 2013.

But when Mr Douglas received his lump sum the ATO took out tax and superannuation, leaving him with just $107,000.

Peter Burns, a former Army diesel mechanic, is also part of the action against the ATO.

Peter Burns injured his back and was discharged from the Army. ( Supplied: Peter Burns )

Injuries he sustained while serving meant he had to have his back fused. He left the military after seven years, ending his personal dream to serve the nation.

His fortnightly payments are taxed, unlike civilians who receive similar disability benefits.

"It's beyond my comprehension as to why," he told 7.30.

"The reason why we took the ATO on was so that we could be treated just the same as everybody else."

ATO, Treasury change rules while case underway

Lawyer and veteran Daniel Paratore is acting for veterans who are challenging the ATO over medical discharge payments. ( ABC News: Christopher Gillette )

The veterans are now challenging the ATO over whether that medical discharge benefit, an invalidity payment, is an "income stream".

"It's not income, in any sense of the word," Mr Paratore said.

He pointed out the veterans' benefits were subject to an annual review by the military.

"If someone else has the power to turn off that income stream, then how is it an income stream?" he said.

"It can't be an income stream."

A year ago, with the court case already underway, Justice John Logan told the ATO there was a "fatal flaw" in its argument — there was no regulation covering "income stream benefit".

The ATO asked for an adjournment, but Justice Logan was cautious, concerned the Federal Government could "make a regulation and even to make it retrospective".

Within months that was exactly what happened.

Tax Office and Treasury emails obtained by 7.30 showed authorities were concerned by the "risk of [the] significant and unintended impacts from pending AAT decision".

'Retrospective legislation crippling'

Wayne Douglas, pictured with his daughter, said the government's actions were "un-Australian". ( ABC News: Michael Vincent )

On December 7 then-assistant treasurer Stuart Robert, also a veteran, introduced amendments to the tax regulation, which were passed by parliament, changing the law retrospectively.

It was backdated to 2007.

In a letter obtained by 7.30, Mr Robert denied the amendments he introduced were created to "specifically disadvantage" the three veterans in their test case.

"That's rubbish. That's absolute rubbish," Mr Paratore said.

"It only arose because of these test cases."

Mr Robert declined to be interviewed by 7.30.

"I think it's un-Australian, as someone who's spent their life serving what the country's asked us to do and to have the Australian government write retrospective legislation against us is crippling," Mr Douglas said.

"To me, the government is there to administer the country on behalf of the people, not to undermine their position. Particularly not the veterans."

Veteran and Federal Labor MP Mike Kelly served with Mr Douglas in Somalia.

"We're obviously concerned about any aspect of retrospectively when you're dealing with these situations," he told 7.30.

"This really does need to be reviewed. And our veterans and our service people deserve to be properly supported."

The ATO declined to comment on the story.

"This matter is currently before the Administrative Appeals Tribunal and for secrecy and privacy reasons we cannot comment on the taxation affairs of particular taxpayers or communications that pertain to litigation involving a particular taxpayer," it said in a statement.

A judgement in the AAT case is due later this year and the veterans are hoping the new Parliament will disallow the change in regulations.