Edited version of private ruling

Authorisation Number: 1011833017707

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Ruling

Subject: Assessability of settlement sum

Question and answer:

Is the lump sum payment that you have been offered for the settlement of your claim under your salary continuance insurance policy assessable income?

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts:

You were permanently employed by a company.

The company had a salary continuance insurance policy in place which provided insurance cover to you.

You were injured in an accident.

Due to your injuries, you ceased employment with the company a short time after the accident.

You made a claim under the employer's insurance policy and received monthly "total disablement benefit" payments for several years.

The monthly "total disablement benefit" payments were calculated based on the income you received when you worked at the company.

After several years of providing payments, the insurer stated you were no longer entitled to the monthly total disablement benefits and refused to make any further payments to you.

You commenced legal proceedings against the insurer.

You claims included:

An order that the defendant specifically perform the policy

A declaration that you are and were entitled to the total disablement benefit or alternatively, damages.

Interests and costs

A draft Release Agreement has been prepared with a view to settling this dispute.

Under the draft Release Agreement, you will receive a settlement sum in return for your agreement to discontinue legal proceedings and grant releases from all past or future claims under the policy in favour of the insurer.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Subsection 6-1(1)

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 10-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-1

Income Tax Assessment Act 1997 Subsection 118-37(1)

Reasons for decision

Subsection 6-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that assessable income consists of ordinary income and statutory income.

Ordinary income

Ordinary income is income according to ordinary concepts (subsection 6-5(1) of the ITAA 1997).

The courts have identified a number of factors which indicate whether an amount has the character of income according to ordinary concepts.

A frequent characteristic of income receipts is an element of periodicity, recurrence or regularity (FCT v. Dixon (1952) 86 CLR 540; (1952) 10 ATD 82).

One or more of the following characteristics will combine with periodicity to give an amount an income nature:

· it is made in substitution of income

· it is made to provide financial support, for example, as an income supplement, or

· it is received in circumstances where the recipient has an expectation of receiving the payment on a regular basis so that the recipient is able to depend upon the payment for his or her regular expenditure.

Payments for rendering personal services are ordinary income and are included in assessable income under section 6-5 of the ITAA 1997.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted. Compensation payments, such as workers compensation, which substitute income have been held by the courts to be income under ordinary concepts (FC of T v. Inkster (1989) 20 ATR 1516; 89 ATC 5142).

Periodic payments received by a taxpayer during a period of disability under a personal accident, income protection or disability insurance policy are assessable on the same principle as workers compensation, that is, they are assessable where they are paid to replace lost earnings (FC of T v. D.P. Smith 81 ATC 4114; (1981)11 ATR 538).

Although a lump sum payment under a personal accident, income protection or disability insurance policy is not a periodic payment, the above principle may also apply to a lump sum paid to settle all outstanding claims under the policy. To determine the character of such a lump sum, it is necessary to consider the terms of the particular policy and the reason for making the payment.

Taxation Determination TD 93/58 explains the circumstances in which a lump sum compensation/settlement payment is assessable, and states that such a payment is assessable income:

· if the payment is compensation for loss of income only (even when the basis of the calculation of the lump sum cannot be determined), or

· to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

The issue of whether a lump sum paid in settlement of claims under an income replacement policy was assessable income was considered in Sommer v. FC of T 2002 ATC 4815; 51 ATR 102 (Sommer's Case), and in Gorton v FC of T 2008 ATC 10-018; 72 ATR 201 (Gorton's Case).

In Sommer's Case, the taxpayer was unable to work as a result of a disability. He had an income replacement policy with an insurer which provided for monthly benefits during a period of disability. The taxpayer made a claim for payment of the monthly benefits but the insurer denied liability. He commenced legal proceedings, claiming the monthly benefits for the period until he was able to return to work, and interest. The claim was settled with the insurer, and a lump sum was paid in settlement of claims under the income replacement policy. The terms of settlement were that upon payment of the lump sum, the policy was cancelled and the taxpayer had no further rights under the policy.

The policy covered rehabilitation and hospitalisation expenses but no such expenses were claimed by the taxpayer. The only claim made by the taxpayer was for income replacement benefits. That claim, which was for past and future benefits, was settled by the terms of settlement.

The taxpayer argued that the settlement amount was a payment of capital as it was paid in consideration of the cancellation of the policy and the consequential surrender of all further rights under the policy. The Commissioner of Taxation argued that the settlement amount was paid in settlement of the taxpayer's claims for the monthly income replacement benefits and, being in satisfaction of an entitlement to income, was itself income.

It was held in Sommer's Case that the settlement amount was assessable income. The rights surrendered by the taxpayer related to his claim to be paid monthly disability benefits payable under the policy. The fact that the payment of the monthly benefits was made in one lump sum did not change the revenue character of the receipt where it was essentially designed to compensate the taxpayer in respect of his income replacement claims, or was a payment in substitution of those claims. The substance of the settlement was that it was a full and final settlement of the dispute between the taxpayer and the insurer in relation to the taxpayer's past and future claims to be entitled to income replacement benefits as a result of his disability.

In Gorton's Case, the taxpayer worked as a medical practitioner until injuries received in a motor vehicle accident prevented him from continuing in his practice. Thereafter, he received monthly payments under a professional income replacement insurance policy. These payments continued for several years until the insurer denied further liability under the policy. Negotiations with the insurer resulted in the taxpayer signing a deed of release which extinguished the policy and any right for him to make further claims under it. In return, the insurer made a lump sum payment to him. The only benefit which the policy provided was a monthly payment which was calculated by reference to average monthly income earned. The policy gave no guidance on the manner in which the lump sum paid to the taxpayer was calculated. The taxpayer believed that he would continue to receive the monthly payments from the insurer until he was 65 years of age, and referred to calculations to demonstrate that he would have received considerably more than the lump sum which the insurer ultimately paid to him. The decision in Sommer's Case was applied, and it was held that the lump sum payment was ordinary income, and therefore, assessable income.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997).

These specific provisions are listed in section 10-5 of the ITAA 1997. The list includes capital gains, which are included in assessable income by virtue of the CGT provisions.

CGT provisions

Section 102-5 of the ITAA 1997 provides that your assessable income includes your net capital gain (the total of capital gains for the income year, reduced by certain capital losses).

However, amounts otherwise included in your assessable income do not form part of a net capital gain (section 102-1 of the ITAA 1997).

Taxation Ruling TR 95/35 considers the CGT consequences for a person who receives an amount as compensation. The ruling states that a right to seek compensation is an asset for the purposes of the CGT provisions, and that a right to seek compensation is:

· acquired at the time of the compensable wrong or injury, and

· disposed of when it is satisfied, surrendered, released or discharged.

TR 95/35 discusses compensation received under a policy of insurance, and states that an insured's right of indemnity under an insurance policy is a right to seek compensation.

There is a CGT exemption for compensation or damages you receive for any wrong or injury you suffer in your occupation, or for any wrong, injury or illness you suffer personally (subsection 118-37(1) of the ITAA 1997).

Application to your circumstances

Your salary continuance insurance policy provided for the replacement of income as a result of injury or total disablement. The benefits that you received in relation to this policy were to replace lost earnings and were calculated with reference to your usual income. The purpose of these payments was a substitute for the income which you would otherwise have earned. They are therefore ordinary income and are included in assessable income under section 6-5 of the ITAA 1997.

If you accept the offer of the lump sum settlement payment, the lump sum payment will be in full settlement and final satisfaction of your claim. That is, it constitutes a full discharge by your insurer of its obligation to pay you income replacement benefits in respect of your claim under the salary continuance policy. As a condition of the settlement your policy will be cancelled.

The lump sum settlement payment is to be paid in settlement of your claim for future income replacement benefits and, being in satisfaction of an entitlement to income, is itself income. The fact that the payment will be made in one lump sum does not change the revenue character of the receipt as it is essentially designed to compensate you in respect of your income replacement claims, or is a payment in substitution of those claims.

Consequently, the lump sum settlement payment which relieves your insurer of the obligation to make future income replacement payments to you retains its character of income and is assessable as ordinary income under section 6-5 of the ITAA 1997 (as in Sommer's Case and Gorton's Case).

In your case, the lump sum payment that you will receive in settlement of your claim for income replacement benefits is included in your assessable income under section 6-5 of the ITAA 1997, and so does not form part of a net capital gain (section 102-1 of the ITAA 1997). That is, the CGT provisions do not apply to the lump sum settlement payment as it is otherwise included in your assessable income, as ordinary income.

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