Edited version of private advice

Authorisation Number: 1012684553657

Ruling

Subject: Assessability of out of court settlement sum

Questions and answers

1. Is the settlement sum you received ordinary income?

Yes.

2. Are you entitled to a deduction for the legal costs incurred in disputing the employment contract?

Yes.

This ruling applies for the following periods:

Year ended 30 June 2014

The scheme commenced on:

1 July 2013

Relevant facts and circumstances

According to your employment agreement, you were entitled to a payment should specific conditions be met. The employment agreement at Section X provides that for avoidance of doubt, the additional amount in question shall be treated as salary or wage.

You argued that the conditions had been met, however, the employer refused to pay the amount.

You sued the employer for breach of contract and sought to enforce the contractual entitlement to the payment.

Your employer counter claimed against you. You denied the allegations and were preparing to defend them in court but the overall settlement was reached which resolved all issues between the parties.

You settled out of court. You received a settlement sum under the terms of the settlement deed.

You incurred legal costs in relation to this action.

Relevant legislative provisions:

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

Income Tax Assessment Act 1997 Subsection 6-5(2).

Income Tax Assessment Act 1997 Subsection 8-1.

Income Tax Assessment Act 1997 Subsection 118-20.

Reasons for decision

Assessability of settlement sum

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that your assessable income includes income according to ordinary concepts, which is called ordinary income. Subsection 6-5(2) of the ITAA 1997 states that if you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

An amount paid as compensation or damages generally acquires the character of that for which it is substituted (FCT v Dixon (1952) 86 CLR 540). Compensation payments which are a substitute for income will be income according to ordinary concepts, even if received in a lump sum (Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? (TD 93/58)).

As a general rule, a judgment or settlement sum paid to compensate a plaintiff for what would have been income or revenue profits to the plaintiff will be on revenue account. In other words, the fact that a taxpayer is denied ordinary income and has to recover that amount through litigation will not alter the character of the amount assessable income (Glennan v FC of T 99 ATC 4467 and Sommer v FC of T 2002 ATC 4815 (Sommer's case)).

The starting point is to characterise the payment made under the agreement. The terms of the agreement must be examined together with the circumstances surrounding its execution, its operation and the receipt of the money in question. (Sommer's case and Allied Mills Industries Pty Ltd v FC of T 89 ATC 4365). Also one must characterise the "substance and commercial reality" of the payment (Sommer's case). In Sommer's case the "substance and commercial reality" of the payment was that it settled past and present income claims of the taxpayer in circumstances where the purpose of the insurance policy was to fill the place of a revenue receipt. As a result, the payment was clearly received on a revenue account. The fact that the payment was received in one lump sum did not change its revenue character (Sommer's case).

Out of court settlements may comprise a claim made up of a number of items depending on the heads of claim or damages, some revenue or capital nature. In these circumstances if the gross amount is not specifically allocated to various items making up the claim and it cannot be dissected into component parts, the compensation will be of a capital nature (McLaurin v FC of T (1961) 104 CLR 381; (1961) 8 AITR 180 (McLaurin's case) and Allsop v FC of T (1965) 113 CLR 341; (1965) 9 AITR 724 (Allsop's case)). However, different components of a lump sum compensation payment can sometimes be identified and those components that are of an income nature will be assessable as such (TD 93/58). The Commissioner's view in TD 93/58 provides that an item will be assessable income under section 6-5 of the ITAA 1997 where:

(a) The payment is payment is compensation for loss of income only e.g. past year profits, and/or interest (even when the basis of the calculation of the lump sum cannot be determined), or

(b) 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.

In your case, the settlement amount was paid to you pursuant to the settlement deed. The deed provides that the settlement relates to the entitlement provided for in the employment agreement. The employment agreement at section X provides that for avoidance of doubt, the additional amount in question shall be treated as salary or wage.

Any component of the settlement sum that relates to the amount that would have been paid to you by your employer under the contract of employment and accordingly would have been paid in respect of the employee/employer relationship. Accordingly, the amount is of an income nature and assessable under section 6-5 of the ITAA 1997.

In relation to the counter claim made against you, you denied the allegations and were preparing to defend them in court but the overall settlement was reached which resolved all issues between the parties. You were not seeking any further compensation or payment in relation to the counter claim. The full amount of the settlement therefore relates to the payment under the employment contract and is assessable under section 6-5 of the ITAA 1997 as ordinary income.

As the entire settlement sum is assessable ordinary income, any capital gain would be offset entirely in accordance with the anti-overlap provisions in section 118-20 of the ITAA 1997.

Deductibility of legal expenses

Broadly, section 8-1 of the ITAA 1997 allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except to the extent the outgoings are of a capital or private or domestic nature, or relate to the earning of exempt income or non-assessable non-exempt income.

Legal costs take their quality as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature. The character of legal costs is not determined by the success or failure of the legal action.

A deduction for legal costs by an employee depends on the particular facts of any case. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. If costs are incurred to dispute the receipt of income contractually owed under an employment contract, then the costs are on revenue account and allowable as a deduction.

The legal expenses would be deductible section 8-1 of the ITAA 1997 where the settlement amount is ordinary income under section 6-5 of the ITAA 1997. If there is an apportionment of the settlement amount between income and capital, then the legal expense would need to be apportioned accordingly. Where the settlement amount wholly a capital gain, then the legal expenses would not be deductible under section 8-1 of the ITAA 1997 and the amount should be included in the cost base.

Where a deduction for legal costs is available to the recipient under section 8-1 of the ITAA 1997, a settlement or award in respect of legal costs will be included in the recipient's assessable income as an assessable recoupment under Subdivision 20-A of the ITAA 1997 (Taxation Ruling TR 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment (TR 2012/8)). If a deduction for legal costs is not available under section 8-1 of the ITAA 1997, any amount identifiable as a reimbursement of those legal costs will not be included in assessable income (TR 2012/8).

In your case, it has been established that the entire settlement sum is assessable ordinary income. Therefore, you are entitled to a deduction for legal expenses under section 6-5 of the ITAA 1997.

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