MUAHAHAHA! I figured it out, through various posts from YEARS ago! this should be better documented!

https://askubuntu.com/questions/313544/spdif-input-not-working

https://bbs.archlinux.org/viewtopic.php?id=177832

There is no setting to do this in pavucontrol or plasma system settings. Instead open a terminal and start alsamixer, once launched I had to press F4 to go to the capture list, then use left+right arrow keys to go over to S/PDIF, then press spacebar to activate capture! so far its working good, and sounds clear as a bell, and I can hear the audio from both the linux host and the windows guest at the same time :)

sudo alsamixer:

https://i.imgur.com/of58R8G.png

​