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Ruling

Subject: compensation payment

Question

Is the compensation payment you received assessable as ordinary income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are: 

· the application for private ruling, and

· the documents provided in response to the request for further information.

The company is a small business entity with a turnover of less than $2 million.

The company entered into an agreement to provide services for a consortium conducted by several other parties (the parties).

The company claimed that the other parties unlawfully terminated the agreement, resulting in the company suffering loss and damages.

This allegation was denied by the parties; however they were eager to settle the dispute without the expense of litigation.

The company, by Writ and Statement of Claim, commenced proceedings in court.

An out of court settlement was reached between the company and the parties.

As part of the settlement, the parities acknowledged and agreed that a payment of $X would be made to the company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Reasons for decision

Question 1

Section 6-5 of the 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 3 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.

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, damages and insurance payments which are a substitute for income are themselves ordinary income. This is so even if the compensation is received as a lump sum. A payment made in connection with terminating, breaching or varying trade contracts, for example compensation or damages for the loss of anticipated profits, will be ordinary income in the hands of a business.

An amount received for the cancellation of a contract was considered to be income in Heavy Minerals Pty Ltd v FCT (1996) 115 CLR 512; 40 ALJR 280. The company was involved in rutile mining. Contracts were made to supply overseas companies with the mineral. The following year the customers wished to be released from their agreements, paying a lump sum payment to do so. The High Court considered these payments to be income as the contracts that were cancelled were not part of the capital of the business. The taxpayer still owned the capital assets of the business such as the plant and the mine.

This was the same in Allied Mills Industries Pty Ltd v. FCT 89 ATC 4365; (1989) 20 ATR 457 (1989) 20 FCR 288 (1989) 93 ALR 157 where the company had an agreement with Peak Frean Australia to distribute one its products. This contract was later cancelled and a lump sum payment of $372,700 made to terminate the agreement. The Full Federal Court found this payment to be income as it was for giving up a right that was part of the normal course of its business. It was for the loss of profits that would have come from the previous agreement.

Application to your circumstances

In this case, the company entered into a contract to provide marketing services to a consortium. The agreement was then unlawfully terminated. The company sought compensation by a Writ and Statement of Claim. The parties of the consortium were eager to resolve the dispute and an out of court settlement was reached. As part of the settlement, the company was entitled to a total payment of $X.

This payment is considered to be a substitute for the income the company would have received had they carried out the contract. The compensation payment is income as it was received for giving up a right that is part of the normal course of business for the company. It was for the loss of profits that would have come from the agreement with the consortium. Therefore, the payment will be assessable income under section 6-5 of the ITAA 1997.

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