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  • Structured settlements – information for lawyers

    If you are a lawyer, here you will find information about changes to the tax treatment of structured settlements and structured orders. You will need to refer to relevant legislation before providing any detailed advice to clients.

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    What are the changes to the tax law?

    The Taxation Laws Amendment (Structured Settlements and Structured Orders) Act 2002 has amended the Income Tax Assessment Act 1997, the Income Tax Assessment Act 1936 and the Life Insurance Act 1995. These amendments make the periodic payments derived from structured settlements and structured orders tax-exempt. Previously structured settlement annuities were taxable. The new rules apply to structured settlements and structured orders entered into on or after 26 September 2001.

    What are structured settlements and structured orders?

    Structured settlement

    A structured settlement is a way of settling a claim for personal injury compensation so that instead of the injured person (claimant) receiving a lump sum settlement they receive at least part of their compensation in the form of periodic payments (annuities).

    As a structured settlement can only be entered into by the injured person or their legal personal representative, it is not possible to have a structured settlement where the person has died. It is not possible to enter into a structured settlement after the parties have settled the case or a court has awarded damages.

    Structured settlements are the result of an agreement between the parties to a personal injury case. The parties to the settlement will generally be the injured person or their legal personal representative, the defendant and their insurer.

    Instead of the injured person receiving a single lump sum payment of compensation from the defendant or the defendant's insurer, they receive all or part of their compensation in the form of tax-exempt periodic payments (annuities).

    There is no special requirement under the tax legislation for structured settlements to be approved by a court. There may be other reasons why court approval must be obtained (for example, one of the parties to the claim is under a legal disability).

    Structured order

    A structured order will have the same outcome (and components) as a structured settlement (at least part of the compensation being paid in the form of periodic payments), but is the result of an order that has been made by a court, often without the consent of the parties. Structured orders will only be possible where a court has power to impose a judgment involving periodic payments of the type satisfying the tax rules for structured orders.

    As structured settlements are expected to be far more common that structured orders, they are the primary focus of this document.

    What are the components of a structured settlement?

    An injured person can only enter into a structured settlement if the lump sum compensation payment, that would have been received under the settlement or awarded if their case was decided by a court, would have been a non-assessable capital payment.

    Instead of a defendant paying the entire final settlement sum to the claimant in the form of a single lump sum, the settlement money is paid in a form that can comprise up to three components. These components must satisfy certain conditions to be eligible for the tax exemption.

    Compulsory component

    A structured settlement must include one or more personal injury annuities that together will provide the injured person with a minimum level of monthly payments over their lifetime. The minimum level of the annuity or annuities is equal to the basic age pension and pension supplement. You can contact Centrelink to find out the current level of the age pension.

    The defendant or their insurer must use all or part of the settlement money to purchase these annuities for the injured person. The personal injury annuity component is compulsory for all tax-exempt structured settlements. This component is usually used to cover future medical treatment, nursing care and other living expenses.

    Optional components

    Immediate cash component

    A structured settlement will often include a cash component that is paid to the injured person immediately after the settlement has been arranged. This means that the defendant will pay part of the compensation money to the injured person as an immediate lump sum that can be used to pay costs, pay debts, purchase equipment, invest and so on. This component is optional, but most injured people will need some cash immediately after the settlement of their case.

    Other optional components

    A structured settlement that includes the compulsory personal injury annuity providing the minimum necessary periodic payments (the compulsory component) can also have:

    • other personal injury annuities (which have more flexible conditions than the compulsory minimum annuity)
    • personal injury lump sums (which can provide tax-free lump sums at pre-agreed future dates to cover expected expenses).

    The defendant will use part of the settlement money to purchase these annuities and lump sums for the injured person.

    What is a personal injury annuity?

    A personal injury annuity is an annuity that is purchased under the terms of a structured settlement. In order to be treated as tax-exempt it must satisfy certain conditions set out in the Act:

    • The source of the money used to purchase the policy must come from the settlement.
    • The annuity must be purchased from an Australian life insurance company or a State insurer.
    • The wording of the policy instrument, in terms of identifying the structured settlement, should specify to whom the payments can be made and not allow for commutation (that is the conversion of the annuity into a lump sum payout) or assignment (that is the transfer to another person).
    • The agreement must specify  
      • the payments allowed
      • the frequency of payments
      • the term or length of the annuity, which must be at least for 10 years or for the life of the injured person
      • the date for the commencement of the annuity
      • the date of payment
      • the allowed basis for increases.
       
    • The agreement must specify the guarantee period (if any) including who will receive the annuity payments in the event of death of the injured person.
    • The personal injury annuity or annuities must satisfy the requirement for the minimum monthly level of support.

    This last condition requires that the personal injury annuity (or a combination of these annuities) must provide the injured person with a monthly amount that equals or exceeds the minimum monthly level of support. This effectively requires a lifetime annuity providing monthly payments that are equal to or more than one-twelfth of the current annual age pension and increase in line with the All Groups Consumer Price Index (CPI) or full-time adult average weekly ordinary time earnings (AWOTE) or by a percentage specified in the annuity instrument.

    Once such an annuity is in place, other personal injury annuities are allowed which are more flexible in terms of payment term, payment frequency and indexation. These other annuities need not be for the life of the injured person (they must have a term of 10 years or longer, provided the payments stop when the injured person dies), must be paid at least annually and the payments need not be indexed, or can be indexed in a range of different ways.

    Under a structured settlement, personal injury annuity payments can be guaranteed for up to 10 years. If a guarantee period of 10 years is chosen this will mean that if the injured person dies within 10 years from the date of settlement then the remaining payments (that would have been paid if the injured person had lived out the 10 years) can be paid tax-free to his or her reversionary beneficiaries. If the beneficiaries wish to, they can commute the remaining payments to a lump sum. If the remaining payments are to be paid to the injured person's estate, they must be paid as a lump sum. If the personal injury annuity commences after the date of the settlement the guarantee period will be less than 10 years. It will not be possible to have a guarantee period if the personal injury annuity is to commence later than 10 years after the date of settlement. The guarantee period only applies to personal injury annuities.

    What is a personal injury lump sum?

    Where there is a personal injury annuity in place that meets the minimum monthly level of support, a structured settlement may also include one or more personal injury lump sums.

    The concept of a personal injury lump sum essentially involves a single premium being paid in return for an agreement to pay a lump sum at an agreed future date or dates. These payments can be scheduled to cover expected future events such as the replacement of equipment.

    The lump sum can be paid only to the injured person or their trustee. Therefore the payments are life-contingent; they can only be paid if the injured person is alive at the agreed future payment date or dates.

    In order to be treated as tax-exempt the personal injury lump sum must satisfy certain other conditions. The instrument under which the lump sum is paid must:

    • identify the structured settlement or structured order under which the lump sum is paid, that is the source of the money used to purchase the policy
    • specify that the lump sum can only be paid to the injured person, or the trustee of a trust of which the injured person is the beneficiary
    • specify the dates and amounts of the lump sums
    • specify the method of indexation of the lump sum by either the CPI or AWOTE index
    • contain a statement to the effect that the right to receive the lump sum can't be assigned, and can't be commuted or otherwise cashed out early.

    What types of cases are affected?

    Only particular types of cases can be structured. The claim must:

    • have been made by a person who has a personal injury, or by their legal personal representative
    • not be made against the defendant in their capacity as an employer of the injured person, or be a workers' compensation claim.

    Most claims will be common law negligence claims for motor vehicle accidents, sporting accidents, product liability, public liability or medical indemnity. Only future and currently open cases can be structured. Structured settlements and structured orders are not possible in cases that have already been resolved.

    Only cases of certain sizes can be structured because the legislation specifies a minimum level of monthly payments. There must be enough compensation money to fund the purchase of an annuity that will provide the injured person with lifetime monthly payments starting at least at the level of the current age pension and pension supplement and increasing in line with the CPI.

    The cost of such an annuity will depend on the life expectancy of the injured person. Less money will be required to provide the minimum amount to an older person with a shorter life expectancy than a young person with a long life expectancy. The cost will vary depending on age, sex, life expectancy and other factors that affect the cost of annuities, such as interest rates.

    What are the advantages and disadvantages of structured settlements for clients

    A structured settlement offers injured people tax savings and financial security. This security comes from shifting investment risk and inflation risk to a large financial product provider. Many claimants will be interested in tax-free payments that are guaranteed to be paid for as long as they live. The downside is less flexibility to the extent that the injured person must give up access to the capital used to purchase the income stream.

    Structured settlements offer defendants a new way of helping to settle claims on a once-and-for-all basis. In appropriate cases they can help to settle cases faster and at no more cost than the alternative lump sum settlement.

    What should I tell my clients about structured settlements?

    To let your client know about the full range of settlement and judgment options available, you need to consider whether a structured settlement is possible in any particular case, and if so advise your client about this option. You may want to encourage the plaintiff to receive expert financial advice regarding lump sums and structured settlement options.

    In some jurisdictions lawyers may have specific legislative obligations to advise on structured settlements and/or structured orders.

    Plaintiff lawyers should ensure that their client understands and considers the structured settlement option. In other countries, plaintiff lawyers have been found to be negligent for not adequately advising their client about the availability of a structured settlement.

    Lawyers will also need to investigate and advise their client whether a structured order can be imposed on the parties, regardless of their wishes.

    Who can provide financial advice to the claimant?

    Personal injury lawyers need to be aware of the impact of the corporations law and its rules regarding financial advice. Those rules generally provide that financial advice must only be given by a licensed financial adviser.

    Lawyers can give legal advice about structured settlements, but need to be careful not to provide financial advice, such as quotes on financial products such as annuities, unless they are appropriately licensed.

    Licensed financial advisers will be able to obtain structured settlement quotes from life insurance companies for personal injury annuities and personal injury lump sums. They can provide injured people with full financial advice that takes into account their total financial position, needs and preferences.

    What settlement documentation is required?

    Once the parties agree to a structured settlement they can then arrange a settlement agreement. To ensure that the periodic payments attract the tax exemption, the tax legislation must be complied with.

    The settlement agreement must:

    • relate to the right type of claim
    • be in writing
    • provide that some of the compensation is being used by the defendant to purchase a personal injury annuity for the injured person.

    The financial product documentation must:

    • identify the structured settlement to which it relates
    • allow payments in accordance with the legislation
    • allow payments to be made to the injured person, their trustee or a reversionary beneficiary
    • not allow commutation or assignment (that is, cashing the product in for a lump sum).
      Last modified: 27 Jun 2019QC 17073