Edited version of your written advice

Authorisation Number: 1012773798622

Ruling

Subject: Workers compensation

Question 1

Will the lump sum payment be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the amount of capital gain attributable to the indemnity be disregarded under section 118-37 of the ITAA 1997?

Answer

No

Question 3

Will the amount of capital gain attributable to medical expenses be disregarded under section 118-37 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period(s)

Income year ended 30 June 2013

The scheme commences on

30 April 2006

Relevant facts and circumstances

You were employed overseas as a contractor.

On x you were involved in a serious workplace injury.

After receiving treatment you were repatriated back to Australia to continue your recovery.

You continued to receive your normal salary until x.

After this time you began to receive compensation payments under a foreign workers compensation statutory scheme.

You were deemed well enough to return to work on reduced duties on x.

However you suffered medical problems after returning from work.

You were medically discharged from your employment on x.

You received weekly compensation payments for total disability from x until x.

You have continued to receive weekly compensation payments form permanent partial disability from x.

You had previously sought a ruling which determined that the weekly payments were assessable as ordinary income.

An order had now been made by a foreign statutory body which has approved a settlement between you and your employer's insurer.

You were paid a lump sum described as an indemnity for $x and an amount of $x for future medical expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-37

Reasons for decision

Summary

We consider that taking into account the entire circumstances around the settlement that the indemnity portion is an undissected lump sum that contains both income and capital components. Consequently the indemnity part of the payment will not be ordinary income but will rather be assessable as capital proceeds from CGT event C2. However as a portion of the undissected lump sum relates to an income component you will not be eligible for the exemption under section 118-37 of the ITAA 1997

Detailed Reasons

Ordinary Income

Subsection 6-5(1) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during that financial year.

Ordinary income is income according to ordinary concepts which is not specifically defined in the legislation. It has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Characteristics of ordinary 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.

Pensions and other similar periodic income replacement payments have the character of ordinary income.

In addition, payments to replace income are also considered to be income (Keily v. Federal Commissioner of Taxation (1983) 14 ATR 156; 83 ATC 4248).

However, an amount paid to compensate for loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82 (Dixon Case).

Commutation of a weekly compensation payments

The Commissioner's view concerning the partial commutation of compensation payments is contained in Taxation Determination TD 93/3. It provides that weekly compensation payments are assessable income because they are paid as compensation for loss of income or salary, or because of their regular receipt and their nature as a supplement to income. The Commissioner views that a lump sum payment, which is a commutation of such payments, retains its character as income. The lump sum payment is essentially an advance of the future weekly payments.

The issue of whether the commutation of an entitlement to periodic payments to a lump sum affects assessability was considered in Coward v. Federal Commissioner of Taxation 99 ATC 2166; (1999) 41 ATR 1138. In that case, Mathews J found that payments made to replace income take on the character of the payment they replace and that the method of payment does not alter the character of the payment. Mathews J held that as the weekly compensation payments made to the appellant until he turned 65 were paid for loss of earnings and thus constituted income, a lump sum representing a commutation of those future weekly payments was also income.

The case of Sommer v. Federal Commissioner of Taxation 2002 ATC 4815; 51 ATR 102 confirms that the same principle applies to lump sum payments that are not expressly commutations of weekly benefits. The case involved a medical practitioner who had taken out a Professional Income replacement insurance policy. Following rejection 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. Alternatively, he argued that the amount comprised an un-dissected aggregation of both income and capital and therefore should be treated as capital.

In dismissing the taxpayers appeal it was held that:

1. The terms of the agreement referred to the relevant surrounding circumstances. Accordingly, it was difficult to argue that the surrounding circumstances were not relevant to the characterisation of the settlement amount. The true nature and proper characterisation of the settlement amount was to be determined by having regard to the policy, the taxpayer's claims under the policy, the terms of settlement which settled those claims, and the rights the taxpayer would be surrendering upon cancellation of the policy.

2. The fact that the payment of the monthly benefits was made in one lump sum did not change the revenue character of the receipt if it was essentially designed to compensate the taxpayer in respect of his income replacement claims or was a payment in substitution of those claims. The substance and commercial reality of the settlement was that it was a full and final settlement of the dispute between the taxpayer and the insurer in relation to the taxpayer's past and future claims to be entitled to income replacement benefits as a result of his disability since August 1996.

3. As the settlement amount did not relate to claims, entitlements, or benefits of an income and capital nature the question of apportionment did not arise.

While TD 93/3 provides the Commissioners view that commutations of weekly compensation payments are assessable as income, it does make the distinction between a partial commutation and redemption of all the injured worker's rights under the Compensation Act. It provides that such payments are capital in nature and therefore not assessable as ordinary income. Further it provides that those payments are exempt from CGT under section 118-37 of the ITAA 1997.

Earning Capacity

In some situations compensation may be for a loss of earning capacity as opposed to loss of income, the case of FCT v Slaven (1989) 52 ALR 8184 ATC 4077; 15 ATR 242 dealt with one such situation. In that case the taxpayer received a payment under the Motor Accidents Act (Vic) 1973 following an injury in a motor accident.

Under the Motor Vehicle Act (Vic) 1973 an amount awarded to an injured person is described as compensation 'for the deprivation or impairment of earning capacity' which the injured person has suffered as a result of the injury. It was held that the essential character of the payment was compensation for loss or impairment of earning capacity and not payments in substitution for lost earnings. Consequently as earning capacity was a capital asset the compensation was not assessable as ordinary income.

In response to Slaven the ATO issued Taxation Ruling IT 2193 confirming that the decision should be applied to other case where the payments have the nature of compensation for deprivation or impairment of earning capacity.

The case of FCT v Inkster (1989) 20 ATR 1516 considered whether workers compensation payments were of a revenue or capital nature. In that case the taxpayer worked as fitter for the railways in Western Australia from 1948 to 1950, during which he was exposed to asbestos dust. He then worked as a policeman until he retired in 1982 upon achieving the age of 60. After commencing a claim the taxpayer received regular payments which were calculated by subtracting the minimum wage from the wage a fitter with the railway would have earned.

The majority judgement held that in this case there was no loss of income to which the payments were directed as a substitution for such earnings, and the payments had their genesis in an assessment of a loss of earning capacity. For this reason any one payment may have had the character of capital rather than revenue. It was the periodic nature of the payments that rendered them as ordinary income and if the taxpayer had been able to commute those payments they would have been capital in nature.

Undissected lump sum and capital gains tax

McLaurin v. Federal Commissioner of Taxation (1961) 104 CLR 381; (1961) 12 ATD 273; (1961) 8 AITR 180 and subsequently Allsop v. Federal Commissioner of Taxation (1965) 113 CLR 341; (1965) 14 ATD 62; (1965) 9 AITR 724 raised the proposition that where a lump sum compensation payment can be dissected into its constituent income and capital components, the income components may be assessable. The Commissioner confirmed this view in Taxation Determination TD 93/58 and indicated that any part of a lump sum compensation amount will only be assessable as ordinary income:

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

b) to the extent that a portion of the lump sum is identifiable and quantifiable as income. This is possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

The Commissioner has released ATO ID 2003/707 which deals with a circumstance where a taxpayer receives a settlement offer which was both a redemption of the taxpayer's entitlement to weekly compensation payments and medical expenses and additionally to surrender their rights to any other future claim against their employer. The Commissioner's view in such a situation is that the lump sum payment to the taxpayer would comprise compensation for a mixture of income and capital items and the payment cannot be dissected into its constituent parts, the payment will not be assessable as ordinary income.

Taxation Ruling TR 95/35 deals with the capital gains treatment of compensation receipts. The Ruling advocates a "look-through" approach, which identifies the most relevant asset to which the compensation amount is most directly related.

Paragraph 11 of TR 95/35 states that if an amount is not received in respect of an underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Any payment received in respect of giving up that right would represent capital proceeds of a CGT event C2 under section 104-25 of the ITAA 1997.

Section 118-37 of the ITAA 1997 provides that any capital gain or loss you make form a CGT event relating directly to compensation or damages you receive for any wrong or injury you suffer in occupation.

Paragraph 20 and 21 of TR 93/35 deal with whether the exemption under section 118-37 of the ITAA 1997 is available for an undissected lump sum:

Exemption under subsection 160ZB(1) is available if the taxpayer receives compensation in an undissected lump sum which relates wholly to the personal wrong or injury suffered by the taxpayer. Refer to Example 17 in this Ruling.

However, if compensation is received by a taxpayer in a lump sum paid in settlement of a number of claims, including a personal injury claim, and its individual components cannot be determined or reasonably estimated, no part of the compensation can be quantified as relating to the personal injury of the taxpayer. Accordingly, the exemption under subsection 160ZB(1) does not apply to any part of the compensation. Refer to Examples 12 and 13 in this Ruling.

Although relating specifically to the now repealed section 27A of the ITAA 1936 we consider the case of Dibb v Commissioner of Taxation [2004] FCAFC 126 supports the above position. In our view the case confirms that if an amount is truly undissected where there were clearly rights to income-type payments as well as rights relating to personal injury that are extinguished in the settlement, the exemption in section 118-37 of the ITAA 1997 can not apply.

Also relevant is the case of Purvis v. FC of T [2013] AATA 58, where the Administrative Appeal Tribunal considered the tax consequences of a Qantas pilot receiving a lump sum insurance payment for the loss of licence. Although the loss of licence came about as a result of illness or injury, the Tribunal found that the payment did not relate directly to compensation or damages within 118-37(1)(b). The amount was calculated without regard to the nature of the personal injury suffered, save that the personal injury had to result in the loss of licence.

Application to your circumstances

You have argued that the terms of the settlement expressly provided that the amount payable is not a commutation of the weekly benefits you were receiving. However the settlement merely provides that you did not receive the 'full benefit' of a commutation which suggests that there was at least a partial commutation or redemption of your future weekly payments. Further as per Sommer a settlement payment does not take its character purely based on the terms of the agreement, rather a substance over form approach is taken having regard to the entire circumstances surrounding the settlement.

While the amount assigned to medical expenses is clearly capital in nature and disregarded under 118-37 of the ITAA 1997 we consider that the indemnity portion of the settlement payment is an undissected lump sum made up of the following elements:

• a partial commutation or redemption of your future weekly compensation payments

• discharge of any liability the employer or insurer has in relation to the injury suffered.

The Commissioner accepts that where an undissected lump sum has components of both income and capital nature and that amount can't be reasonable apportioned then the whole payment is capital in nature. However in such a situation where there is a component that relates to income the exemption under section 118-37 of the ITAA 1997 will not apply.

Consequently in your circumstances the exemption under section 118-37 of the ITAA 1997 will turn on the character of the weekly compensation payments and whether those payments retain that character when they are redeemed in a lump sum. Essentially this involves an exercise similar to that of Inkster in determining whether the permanent partial disability payments are compensation for loss of income or compensation for your reduced earning capacity.

Your situation is distinguishable from Inkster in that your entitlement to payments was conditional on an actual loss of income. If you were to earn income above your pre injury wages levels you would have extinguished your right to receive those payments, whereas the taxpayer in Inkster continued to earn income, which had no bearing on his entitlement to the payment. We consider that the weekly payments have the character of compensation for loss of income or a supplement to income up to your pre injury levels. As per Cowards case such payments retain their income character when commuted or redeemed in a lump sum.

Therefore we consider that the undissected lump sum contains both income and capital items. As no reasonably apportionment can be made between the income and capital components the entire amount will not be assessable as ordinary income. The amounts received will represent capital proceeds form a CGT event C2 which occurred when you entered into the settlement. As the rights which have been extinguished in the settlement have been held for greater than 12 months you will be eligible for the CGT general discount.

We do not consider that all of the elements of the undissected lump relate wholly to the personal injury you suffered. This is evidenced by the fact that the partial disability payments were not calculated with regard to the nature of the personal injury you suffered but rather were calculated by comparing your pre injury wage and what you did or could have earned post the injury. Consequently the capital gain attributed to the indemnity portion of the settlement will not be eligible for the exemption under section 118-37 of the ITAA 1997 as per the Commissioner's view in paragraph TR 95/35.

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