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Ruling

Subject: Assessability of compensation payment

Question 1:

Is the compensation amount you received assessable as ordinary income?

Answer:

No.

Question 2:

Is the compensation amount you received assessable as statutory income (including capital gains)?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts and circumstances

You commenced an income protection policy with an insurance company many years ago.

You were admitted to hospital and deemed unfit for work.

You received regular payments for a short period of time under this policy.

The insurance company then ceased paying your benefits.

You disputed the cessation of the payments and took action to court with the assistance of your legal representatives.

The end result was that you received a Release Agreement which provided that, as a condition of the settlement being offered, your policy would be cancelled and you would receive a lump sum payment in full and final settlement of any future rights, benefits and entitlements.

The amount of the settlement sum was $X.

The Release Agreement stated that the insurer will agree to resolve the proceedings with a one off and final payment in order to avoid the cost, expense and inconvenience of litigation.

The Release Agreement has been entered into with the insurer for the purposes of you surrendering your rights under the insurance policy.

Further, the lump sum has not been paid to compensate you for future income maintenance payments under the policy.

You received the lump sum payment as compensation for giving up your capital rights.

Relevant legislation provisions:

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 6-15

Income Tax Assessment Act 1997 Section 15-30

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(3)

Income Tax Assessment Act 1997 Section 104-155

Reasons for decision

Assessable income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

Your compensation is not income from rendering personal services, income from property or income from carrying on a business. The payment is a one off payment and thus it does not have an element of recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. Compensation for surrendering the right to take legal action is generally regarded as being capital in nature.

In your case, the lump sum payment was made in respect of an agreement not to take legal action against the insurance company. Taxation Determination TD 93/58 - Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? states that any part of a lump sum compensation amount will only be assessable as ordinary income:

(a) if the payment is compensation for loss of income only, or

(b) to the extent that a portion of the lump sum is identifiable and quantifiable as income. This is 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 lump sum compensation payment you received is in settlement of you agreeing not to take legal action against the insurance company. As your lump sum payment is not paid specifically as compensation for loss of income, we consider the lump sum payment is of a capital nature.

Therefore, as the lump sum payment is capital in nature it is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Statutory income

Section 6-10 of the ITAA 1997 looks at amounts that are not ordinary income but are included in assessable income by another provision. These amounts are called statutory income and are also included in assessable income.

The general capital gains tax provisions are set out in Part 3-1 of the ITAA 1997 and so taxable gains under this part would be included as statutory income.

Under the capital gains tax (CGT) provisions a taxpayer will make a capital gain or loss only if a CGT event happens to a CGT asset.

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates.

The Commissioner's policy on the treatment of compensation payments is set out in

Taxation Ruling TR 95/35 Capital gains: treatment of compensation receipts.

Taxation Ruling TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be:

· an underlying asset

· a right to seek compensation, or

· a notional asset in terms of subsection 160M(7) - (section 104-155 of the ITAA 1997).

In determining which is the most relevant asset, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt.

In TR 95/35 the term 'underlying asset' is used. The underlying asset is defined in TR 95/35 as:

· the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part 3-1 of the ITAA 1997. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged. This disposal triggers a CGT event C2 under subsection 104-25 of the ITAA 1997.

In your situation, you received a lump sum compensation payment in relation to the insurance company discontinuing payments under your income protection policy.

The relevant asset is your right to seek compensation for the losses arising from the insurance company discontinuing the payments under your income protection policy, rather than compensation for any wrong, injury or illness suffered by you. You disposed of your right to seek compensation when you entered into a Release Agreement. This triggered CGT event C2.

Accordingly, the lump sum payment that you received from the insurance company is assessable as statutory income under section 6-10 of the ITAA 1997. You will make a capital gain if the capital proceeds from the ending of your right to seek compensation are more than the cost base of the asset under subsection 104-25(3) of the ITAA 1997.

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