Edited version of your private ruling

Authorisation Number: 1012527303971

Ruling

Subject: Income - assessable - lump sum insurance settlement payment

Question 1

Is the lump sum payment that you received to settle a dispute with the insurance provider in respect of an income protection policy assessable income?

Answer

Yes.

This ruling applies for the following period:

Financial year ended 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

1. An individual (the insured) applied for and was granted an income protection insurance policy which provided cover in respect of income protection (IP) and business expenses (BE).

2. The individual is both the sole life insured and policy owner.

3. At all material times, the policy premiums were paid for by the company as trustee for the Trust who traded the business of the insured.

4. The Trust provided the only source of income to the insured by way of motor vehicle allowances and trust distributions.

5. The individual is the sole director and shareholder of the company, who at all times has been the trustee of the Trust.

6. The individual is the primary beneficiary of the Trust.

7. The BE cover provided monthly benefits to cover up to 100% of eligible business expenses for periods the insured was totally disabled up to 12 months.

8. The IP cover provided monthly income in arrears throughout any period the insured was unable to work because of illness or injury, up to the expiration date of the policy. As the insured opted for an additional insurance option, additional benefits to the standard IP cover may be provided to help pay costs associated with the illness or injury. The monthly benefit was calculated as a proportion of the insured's income.

9. The insurance product disclosure statement for your insurance policy advises that, at the time of print, the insurance premiums are tax deductible and that monthly benefits paid to the insured are to be treated as part of the insured's assessable income.

10. The Trust lodged a claim under the insurance policy in relation to an injury sustained by the individual. The claim was made in relation to both the BE cover (the First BE Claim) and the IP cover (the IP Claim).

11. In response to the First BE Claim, the Trust received benefits under the BE cover for a 12 month period.

12. In response to the IP Claim, the Trust received monthly benefits over the next several years on the basis that the insured was partially disabled and at other times, on the basis of total disablement.

13. You have stated that monthly payments received by the Trust are ordinary income because they replace lost income, are periodic and are an income supplement and have accordingly been included in its taxable income.

14. The insurance provider ceased all benefit payments under the policy before the expiration date of the policy.

15. The individual sought legal advice in relation to unpaid benefits.

16. A draft Statement of Claim was served to the insurance provider in respect of the IP claim only. From that time to the 2012-13 financial year, the parties have bee in dispute regarding the ceasing of benefit payments under the insurance policy.

17. The insurance provider advised the insured that there had been an overpayment of benefits during the period of IP benefit payments. The insured's legal representative argued that there had been an underpayment for this period, further calculating that projected trading performance provided a potential entitlement to further benefits from the time the benefit payments ceased to the expiration date of the policy.

18. All parties agreed that the insured was entitled to claim on medical grounds, and that the underlying injuries were such that entitlement would exist continuously until the expiration date of the policy, the dispute turning around quantum.

19. A second claim for business expense benefits under the insurance policy (the Second BE Claim) was lodged in respect of an illness of the insured.

20. The parties agreed to resolve the dispute via settlement. Accordingly, a Deed of Release (the Deed) outlining the terms of the settlement agreement was prepared.

21. The Deed stipulated that, without admission of liability by any party, in consideration of the Deed and the a lump sum payment, the insurance provider would be forever released/discharged from causes of action claim or demands including those that arise out of or in connection with the following subject matter:

a. Any of the matters set out in the Recitals of the Deed (as described in the facts above)

b. The insurance policy

c. The IP claim

d. The First BE Claim

e. The Second BE Claim

f. The dispute

g. All claims the insured had, may have in the future against the insurance provider, under or in any way connected with the policy.

22. The Deed also stipulated:

- that the parties finally and fully settled any and all liabilities, claims, disputes and differences which now exist, may exist or have ever existed between them relating to matters the subject of the Deed

- the insurance policy is cancelled and the individual is no longer insured, nor has he/she any further rights or entitlements under the policy

- the Trust never had an entitlement to claim under the insurance policy as it was not the policy owner

- the insurance provider paid a settlement sum by way of cheque to the trustee of the Trust forever release and discharge the insurance provider from all causes of action, claims or demands relating to matters the subject of the Deed

- the settlement sum includes any tax payable, costs and interest

- the Deed represents the entire agreement by the parties about its subject matter.

23. The matter and the Deed was signed and settled by the parties in the financial year ended 30 June 2013

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that your assessable income includes income according to ordinary concepts, which is called ordinary income.

Ordinary income has been held to include income from providing 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 or relied upon

· have an element of periodicity, recurrence or regularity

· replace income.

A compensation or settlement amount normally assumes the nature of that which it is designed to replace i.e. the replacement principle.  For example, 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. Likewise, payments to replace income are considered to be income. Also, medical expenses are private expenditure and therefore an amount paid to cover this type of expenditure is not assessable income.

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:

(1) if the payment is to replace lost income - assessable as ordinary income

(2) if the payment is for a loss in earning capacity - not assessable as ordinary income because it is a capital receipt

It is well established that, in general, insurance moneys are received on revenue account where the purpose of the insurance was to fill the place of the revenue receipt which the event insured against has prevented from arising (Carapark Holdings Ltd v Federal Commissioner of Taxation (1967) 115 CLR at 633).

In Sommer v. Federal Commissioner of Taxation (2002) 51 ATR 102 (Sommer's Case), ita lump sum paid to a doctor in settlement of his claim under an income replacement policy was assessable on the basis that it was in substitution for his original claim under the policy for lost income. The taxpayer contended that the amount comprised an undissected aggregation of both income and capital and, therefore, should be treated as capital. He also argued that the AAT had not confined itself to the terms of the settlement agreement. In affirming the AAT's decision, the Federal Court said that it was appropriate to take into account the "surrounding circumstances" (which, in fact, were also referred to in the settlement agreement). Moreover, it was clear that when all these circumstances were considered, the substance and commercial reality of the payment was that it was a full and final settlement of all the taxpayer's income claims.

The decision in Sommer 's Case was followed in Re Gorton v. Federal Commissioner of Taxation (2008) 72 ATR 201 and confirmed that determine the character of such a lump sum, it is necessary to consider all circumstances including those leading up to the settlement, the terms of the settlement agreement and the insurance policy and the reason for making the payment.

Your insurance cover provided for the replacement of income as a result of your injury.  The monthly benefits received are income replacement payments that replaced income that you would normally derive, expect and rely on. This payment is considered to be ordinary income as it acquired the character of the income it substituted and therefore will be assessable under section 6-5 of the ITAA 1997.

You have made a statement in line with our view that monthly payments received under the insurance policy are ordinary income because they replace lost income, are periodic and are an income supplement and have accordingly been included in assessable income.

Circumstances leading to the settlement payment includes a Statement of Claim and a documented dispute regarding unpaid insurance benefits under an income protection policy, which affirm are ordinary income and which you have treated as such by including these amounts in assessable income.

The terms of the settlement agreement in the Deed refers to circumstances surrounding the payment in its 'Recital' and identifies the subject matter of the dispute to be settled by reference to claims made under the income protection policy.

In considering all circumstances, the substance and commercial reality of the payment is that it settled past and present income claims in circumstances where the purpose of the insurance policy was to fill the place of an income receipt. Accordingly, the settlement payment is received on revenue account and is assessable ordinary income under section 6-5 of the ITAA 1997.

The fact that the payment was received in one lump sum does not change its revenue character.

Settlement payments that are assessable as ordinary income are derived in the income year of receipt, including constructive receipt, even if they are paid as a lump sum. Therefore, the settlement lump sum that was paid to the Trust in the 2012-13 financial year is considered to have been made available to the individual without restriction, and otherwise 'received' in the 2012-13 financial year. Accordingly, the settlement sum is ordinary income of the individual, to be included as assessable income in the 2012-13 individual tax return.

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