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Ruling

Subject: Assessability of lump sum settlement payment

Question and answer:

1. Is the lump sum payment you received as settlement of legal action included in your assessable income as an amount of ordinary income?

No.

2. Will your assessable income for the 2011-12 financial year include any net capital gain or loss that results from the receipt of the lump sum payment?

Yes.

This ruling applies for the following period:

1 July 2011 to 30 June 2012.

The scheme commenced on:

1 July 2011.

Relevant facts:

You own a residential rental property (your property).

An insurance claim was lodged because of defective building work.

The insurer rejected the claim.

Solicitors were engaged to take legal action against the insurer.

A settlement was reached in relation to the legal action.

As a result of the settlement:

No part of the settlement amount was identified as being related to loss of rental income in the agreement.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 102-5.

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25.

Income Tax Assessment Act 1997 Section 116-20

Reasons for decision

Assessable income - general

The assessable income of an Australian resident taxpayer may include amounts of ordinary and statutory income.

Income earned from a rental property is an example of ordinary income that is included in a taxpayer's assessable income under the provisions of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

Capital gains are an example of statutory income and are included in a taxpayer's assessable income under the provisions of section 102-5 of the ITAA 1997.

Is the lump sum payment assessable as ordinary income?

Compensation payments which are a substitute for income (loss of rental income for example) have been previously held by the courts to be assessable as ordinary income (FC of T v. Inkster (1989) 20 ATR 1516; 89 ATC 5142; Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641; Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

This position by the courts is reflected in Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable?

Taxation Determination TD 93/58 contains the Australian Taxation Office (ATO) view on the circumstances in which the receipt of a lump sum compensation/settlement payment will be assessable as ordinary income in the hands of the recipient.

TD 93/58 specifies that such a payment will be assessable as ordinary income:

No part of the settlement amount was identified as being related to loss of income. Accordingly, no portion of the lump sum settlement amount will be included in your assessable income as ordinary income.

Capital gains tax - general

As an individual taxpayer, any net capital gain you make in an income year is included in your assessable income.

Your net capital gain is:

You make a capital gain or loss when a CGT event happens to a CGT asset that you own.

You make a capital gain if the capital proceeds from the CGT event are more than the cost base of the asset. If the capital proceeds from the event are less than the reduced cost base of the asset, the result is a capital loss.

Capital proceeds are the amount you receive or are entitled to receive as a result of a CGT event.

The cost base of a CGT asset is made up of five elements:

The reduced cost base of a CGT asset has the same five elements as the cost base, except for the third element. The third element of the reduced cost base relates to balancing adjustments which may apply to depreciating assets.

Capital gains tax and receipt of settlement amounts

Compensation/settlement amounts that cannot be directly attributable to loss of income will usually be capital in nature and potentially taxable as statutory income under the CGT provisions of the ITAA 1997. This will be the case if receipt of the settlement amount you received can be attributed to a CGT event happening to a CGT asset you owned.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts specifies that:

You acquired a right to seek compensation on the date the insurer rejected the claim. This right to seek compensation was a CGT asset. You disposed of this CGT asset on the day you agreed to settle the legal action. CGT event C2 happened to your right to seek compensation at that time.

If the lump sum amount you received for disposing of your right to seek compensation is greater than the cost base of that asset, you will have made a capital gain. If the lump sum amount is less than the reduced cost base of your right to seek compensation, you will have made a capital loss.

The cost base of your right to seek compensation will include any legal fees you incurred which were not reimbursed to you as part of the settlement. You can also include any other costs you incurred that can property be attributed to any of the elements of the cost base/reduced cost base of the asset.

Conclusion

The lump sum settlement amount is not included in your assessable income as an amount of ordinary income. However, as you received the lump sum payment as consideration for a CGT event happening to a CGT asset you owned, any net capital gain that arises in the income year in which the payment was received will be included in your assessable income.

General information

You can rely on this advice to provide you with protection from interest and penalties in the way explained below.

If the advice turns out to be incorrect and you underpay your tax as a result, you will not have to pay a penalty. Nor will you have to pay interest on the underpayment provided you reasonably relied on the advice in good faith. However, even if you don't have to pay a penalty or interest, you will have to pay the correct amount of tax.

Amounts paid to correct damage existing when you acquire a property or to correct faulty construction are not deductible expenses. However, such amounts may be included in the cost base/reduced cost base of the relevant CGT asset, a residential rental property for example.

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