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Edited version of your written advice

Authorisation Number: 1012706170867

Ruling

Subject: Income replacement insurance

Question and Answer:

Will the lump sum payment you receive from your insurer under an income protection insurance policy be a capital payment and not assessable as ordinary or statutory income?

No

This ruling applies for the following period:

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commenced on:

1 July 2014

Relevant facts and circumstances

In the early 2000's you suffered an injury (the disability).

As a result, your career was ended.

You took out an income replacement policy with an insurance company (the insurer) in the early 2000's. According to the policy schedule, the policy is for income replacement.

You lodged a claim on the policy in respect of your disability. The insurer commenced periodic payments in accordance with the terms of the policy.

You have since retrained in another career but your earning capacity has diminished.

You have been receiving regular income protection payments and have included them as income in your income tax returns.

The insurer has offered to commute all future benefits under the policy to a one off payment.

You have provided the following:

Please remember that all income benefits are assessable as income under the Income Tax Assessment Act 1997. As such you are required to retain this letter (and all other payment letters) and acknowledge receipt of this benefit in your annual tax return.

You have also provided the proposed Deed of Settlement and Release between you and the insurer. The Deed contains the following Settlement of claim:

In consideration of this deed and the payment by the Insurer to the Claimant of a lump sum of $X (Agreed Sum), the Claimant (for himself, his administrators, heirs, assigns and executors) agrees to release and indemnify and forever discharge the Insurer and all its officers, employees and agents from any liabilities arising in any way out of, on in connection with, the Policy, the Claim, or the Disability.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Reasons for decision

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. 

Section 6-10 of the ITAA 1997 provides that assessable income also includes statutory income, that is, income which is not ordinary income that is included in assessable income by another provision of the income tax legislation. Certain types of insurance receipts and capital gains are examples or statutory income. 

Several types of receipts are not income for taxation purposes as they do not have the characteristics of ordinary income and they are not statutory 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:

A capital receipt does not have the characteristics of ordinary income as it is usually:  

Characteristics of a capital receipt include:  

Whether the payment is a receipt of a capital or income nature in turn depends upon consideration of all the circumstances surrounding the payment. 

For income tax purposes, a compensation amount generally bears the character of that which it is designed to replace. Taxation Ruling TR 95/35, Income tax: capital gains: treatment of compensation receipts, in dealing with the taxation treatment of compensation receipts, suggests the assessability of a lump sum in the hands of the recipient depends on whether it is a receipt of capital or income nature. It is the character of the receipt in the hands of the recipient that must be determined: FCT v. Slaven (1984) 52 ALR 81; 15 ATR 242; 84 ATC 4077 (Slaven's Case). Generally, the material factor in determining whether compensation is of an income or capital nature is not the measure of the compensation, but what it is truly paid for: Glenboig Union Fireclay Co Ltd v. IR Commrs (1921) 12 TC 427.

Taxation Determination TD 93/58, Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable?, in discussing the assessability of lump sum compensation/settlement payments, explains that only lump sum settlements representing compensation for losses of an income nature will be income according to ordinary concepts. 

It was held in McLaurin v. FC of T (1961)104 CLR 381; (1961)12 ATD 273; (1961) 8 AITR 180 (McLaurin's Case) and Allsop v. FC of T (1965) 113 CLR 341; (1965) 14 ATD 62; (1965) 9 AITR 724 and confirmed by the Commissioner in TD 93/58, that any part of a lump sum compensation amount will be assessable as income:  

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

In a Federal Court case, Sommer v. Commissioner of Taxation [2002] FCA 1205; 2002 ATC 4815; 51 ATR 102 (Sommer's Case) involved a medical practitioner who had taken out a Professional income replacement insurance policy. Following rejection by the insurer of the taxpayers claim for income replacement payments of $4,000 per month, the matter was settled out of court with the payment of a lump sum to him. The taxpayer argued that the amount was capital as it was paid in consideration of the cancellation of the policy and the surrender of his rights under it. Alternately, he argued that the amount comprised an undissected aggregation of both income and capital and therefore should be treated as capital.  

In dismissing the taxpayers appeal it was held that:  

18. As explained above, the valuable rights surrendered by the applicant related to his claim be paid monthly disability benefits payable under the policy. The applicant argued that the settlement amount was paid in consideration of the cancellation of the policy which resulted in the surrender of the applicant's right to renew the policy and to obtain future benefits. The rights surrendered were said to be valuable and of a capital nature. However, the applicant's argument that such rights were valuable was not supported by the material before the Commissioner when he made the private ruling. The argument is also not supported by the terms of the policy itself. The right of renewal from year to year is subject to payment of the annual premium, which, in general, could be expected to be commensurate with the risk insured against. Thus, it is not self-evident that the right of annual renewal was a valuable right which was surrendered by the cancellation of the policy. The applicant also sought to rely upon the loss of particular benefits payable under the policy, other than in respect of income replacement, such as minimum benefits for death and particular disabilities and indemnity for rehabilitation and hospitalisation expenses. However, no claims of that kind had been made or threatened by the applicant. Thus, there is an air of unreality and artificiality about the applicant's contention that there was a capital element involved in the cancellation of the policy, and therefore in the settlement amount.

19. The substance and the commercial reality of the settlement was that it was a full and final settlement of the dispute between the applicant and the insurer in relation to the applicant's past and future claims to be entitled to income replacement benefits as a result of his total or partial disability since August 1996. As explained above, it is well established that a payment in settlement of such claims is a payment on revenue account.

An Administrative Appeals Tribunal (AAT) Decision [2008] AATA 0280 Gorton v. Commissioner of Taxation (Gorton's Case) is similar in nature. The case involved a medical practitioner who had taken out a Professional income replacement insurance policy with AMP. He was injured in a motor vehicle accident and was not able to continue in his practice. He received monthly payments under the income protection insurance policy but later the monthly payments were refused as the insurer had deemed that Mr Gorton was in breach of the terms of the insurance policy. After negotiations, a settlement was reached and Mr Gorton received a lump sum payment in return for signing a deed of release for benefit of AMP which extinguished the policy and any right for future claims.

The taxpayer argued that the amount was capital as it was paid in consideration of the cancellation of the policy and the surrender of his rights under it. Alternately, he argued that the amount comprised an undissected aggregation of both income and capital and therefore should be treated as capital.

The Tribunal stated that it was satisfied that the observations in the Sommer's Case were applicable in Mr Gorton's case and the lump sum payment received by Mr Gorton was ordinary income because its character was determined by reference to the payments it replaced which was clearly income. The lump sum continued to bear that character of income and was therefore considered assessable.

In your case, the intention in taking out the income protection policy was to protect and provide income in the event of illness or disability. The lump sum payment that you have been offered is considered assessable income as it is a payment of compensation payments for loss of income that you would have been entitled to receive under the policy with the insurer. The payment is not for your specific injury or disability and thus not for the loss of capital asset.

It is therefore considered that relevant facts of Sommer's Case and Gorton's Case are similar in nature to your case and considered your lump sum payment is of an income nature and assessable under section 6-5 of the ITAA 1997.

Your arguments

You have raised four main arguments. You are currently receiving income replacements from your insurer. They have offered to commute all future benefits under the policy to a one off payment. You consider the lump sum payment is for a reduction in earning capacity and not for loss of income. You are of the opinion that the offer of commutation is based on past, current, and future reduced earning capacity and not on loss of income. It is your view that the payment is a capital amount and not ordinary or statutory income, and that your circumstances can be distinguished from Sommer's Case.

You consider the lump sum payment you will receive from the insurer is for a reduction in earning capacity. Compensation received for loss of earning capacity is a capital asset, and is considered to be of a capital nature and is not ordinary income.

A lump sum payment to compensate a taxpayer for loss of earning capacity is considered to be compensation for personal injury. Where the amount relates to compensation or damages a taxpayer received for any personal wrong, injury or illness, the amount is not assessable income and the capital gain may be disregarded. As such it is disregarded for CGT purposes, and the payment will not be included in a taxpayer's assessable income as statutory income.

Insurance policies for income replacement can be distinguished from other policies such as motor vehicle accident insurance policies. Taxation Ruling IT 2193, Income Tax; Compensation for loss of earning capacity provides the Commissioner's view on compensation payments for the loss of earning capacity resulting from a motor vehicle accident.

In 1979 the Motor Accidents Act was amended in an endeavour to alter the character of payments made to persons injured in motor accidents. As a result of the amendments the amount awarded to an injured person is no longer described as a payment for loss of income or in substitution for income which would otherwise have been earned by the injured person - it is consistently described throughout the Motor Accidents Act as compensation 'for the deprivation or impairment of earning capacity' which the injured person has suffered.

In Slaven's case, the taxpayer was injured in a motor vehicle accident which left her unable to work for a period of nine months. She received compensation for the deprivation or impairment of her earning capacity from the Motor Accidents Board, under the Motor Accidents Act (Vic) 1973. The Board, in determining an adequate amount of compensation to be paid to an injured person, had to have regard to the loss of earnings actually suffered and to the likely loss of future earnings. The Federal Court held that the essential character of the compensation was compensation for loss or impairment of earning capacity, a capital asset, and that it was not liable to income tax.

In your case, whilst you consider the lump sum payment is for reduction in earning capacity, the payment is not specifically for your disability or, for pain and suffering; it is for giving up the right to receive periodical payments and other benefits provided for under your income replacement policy.

Furthermore, your insurer considers the income to be assessable as stated in a letter:

Please remember that all income benefits are assessable as income under the Income Tax Assessment Act…As such you are required to retain this letter (and all other payment letters) and acknowledge receipt of this benefit in your annual tax return.

Receiving the amount as a lump sum does not change the character of the payment.

In your case, your sickness/accident disability insurance policy provides for the replacement of income as a result of sickness or injury. Benefits paid under this policy are paid on a regular basis. The policy covers for loss of income only. 

The sole purpose of the payments under the policy is a substitute for the income which you would otherwise have earned. If you accept the insurance company's offer of the lump sum, the rights that you will be surrendering upon early termination of your policy are the rights to income replacement payments only. The lump sum settlement payment will compensate you in respect of your income replacement claims, and will therefore be compensation for loss of income only.

Consequently, the lump sum settlement payment which will relieve the insurance company of future income replacement payments to you will retain its character of income and is assessable under section 6-5 of the ITAA 1997. Such a payment is not exempt from income tax.

A lump sum payment to compensate a taxpayer for loss of earning capacity is considered to be compensation for personal injury.

Where an amount is paid as compensation for personal injuries, the amount may be of a capital nature. Gibbs J of the Supreme Court of Queensland in Groves v. United Pacific Transport Pty Ltd [1965] Qd. R. 62 at 65 held that personal injuries compensation was really awarded for the impairment of the plaintiffs earning capacity that has resulted from his injuries. 

This view was supported by Barwick CJ of the High Court in Atlas Tiles Ltd v. Briers (1978) 144 CLR 202 where His Honour held that earning capacity was a capital asset. The fact that the loss was measured by a consideration of the actual earnings foregone was merely an exercise in the valuation of the loss and did not change its capital character.  

In your circumstances, the proposed payment is not for your injury and thus not for the loss of earning capacity and consequently not a capital amount.

You consider your circumstances are not similar to those in Sommer's Case. You argue that the amount you have been offered is for reduced earning capacity and it is to replace your income as you are unable to return to your previous occupation. We acknowledge that as a result of your disability, you are no longer able to practise in your previous profession and your current occupation has resulted in a lower salary. However, the payment which has been offered under your policy is for loss of income that you would have been entitled to receive under the policy with the insurer. For this reason your case is similar to Sommer's Case.

Conclusion

Your sickness/accident disability insurance policy provides for the replacement of income as a result of sickness or injury. Benefits paid under this policy are paid monthly. The policy covers for loss of income only. 

The sole purpose of the payments under the policy is a substitute for the income which you would otherwise have earned. If you accept the insurance company's offer of the lump sum, the rights that you will be surrendering upon early termination of your policy are the rights to income replacement payments only. The lump sum settlement payment will compensate you in respect of your income replacement claims, and will therefore be compensation for loss of income only.

The monthly payments that you have been receiving under the policy are to replace lost earnings and not for compensation for your disability. Consequently the lump sum settlement payment which will relieve the insurance company of future income replacement payments to you will retain its character of income and is assessable under section 6-5 of the ITAA 1997. Such a payment is not capital and is not exempt from income tax.

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