Edited version of your written advice

Authorisation Number: 1012853722171

Date of advice: 4 August 2015

Ruling

Subject: Non resident beneficiaries

Question and Answer

Is trustee liable to pay income tax pursuant to subsections 98(2A) and subsection 98(3) of the Income Tax Assessment Act 1936 (ITAA 1936) on the Settlement Sum paid to the non-resident beneficiaries in the year ended 30 June 2015?

Yes

This ruling applies for the following period

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2014

Relevant facts

Nature of investment

1. The Unit Trust (the Trust) is an Australian resident.

2. According to the ruling application:

The purpose of the Trust was to develop and sell land (residential and commercial properties) in Australia and distribute the profit to unitholders.

For tax purposes, it is accepted that the profits had an Australian source.

3. The investors in the unit trust included non-resident beneficiaries; a company (Company A) and other individuals.

4. According to the Clause 1 of the Trust Deed for the Trust, a 'Unit' constituted '…an undivided part or share in the Trust Fund…', with the definition of 'Trust Fund' including both:

….the initial sum and all other moneys paid to and accepted by the Trustee with respect to any applications for units hereunder; [and]

…all income derived by the Fund which may arise from any source whatsoever.

5. Clause 6 of the Trust Deed states:

That the beneficial interest in the Trust Fund as originally constituted and as existing from time to time shall be vested in the Unit Holders for the time being in the manner set forth in this Deed….

6. Clause 81 of the Trust Deed provides:

That the net income of the Fund for the purposes of this Deed shall be the amount which under the provisions of Section 95 of the Income Tax Assessment Act 1936 (as amended) from time to time represents the net income in relation to a trust estate as defined therein, and for such purposes the Trustee may in its absolute discretion determine whether any receipt of outgoing or any sum of money or investment is to be regarded as being on account of corpus or of income or partly on account of one and partly on account of the other.

7. According to the ruling application:

• The Trust developed and sold the properties.

• The Trust will derive a profit for the 2015 year.

• Any bank loans made to the Trust were fully repaid.

8. Based on the Defence and Counterclaim document, the Trustee returned to the X non-resident beneficiaries the capital which they had originally invested in the Trust.

9. The Trustee then commenced the distribution of profits from the development.

10. The Trustee and the other individual parties were the defendants in a legal action undertaken by the non-resident beneficiaries regarding the actions or contended actions of the Trustee, and the entitlement of the non-resident beneficiaries.

Pre-settlement Claims and Counter Claims

11. According to the Amended Statement of Claim lodged by the representatives of Company A with the Supreme Court (Amended Statement of Claim), the Claims made by Company A against the Trustee included accounts, inquiries, declarations and orders in regarding the operations of the Trust and Company A's interest in it, including, inter alia:

(K) A declaration that the Plaintiff is entitled to 50 per cent of the Trust Fund, including and the undistributed income of the Trust,

(L) an order that the Trustee distribute to the Plaintiff 50 per cent of the undistributed income of the Trust.

(M) Alternatively to L, a declaration as to the extent of the Plaintiff's interest in the Trust Fund.

(N) Alternatively, damages.

(O) A permanent injunction restraining the Trustee from dealing with the Plaintiff's interest in the Trust Fund other than at the direction of the Plaintiff.

(P) Alternatively to I, and (sic) order that the Trustee distribute to the Plaintiff the proportion of the undistributed income of the Trust to which the Plaintiff is entitled.

(Q) Such further or other orders as the Court considers necessary or appropriate.

(R) Costs

12. In the Defence and Counterclaim filed by the representatives of the Trustee with the Supreme Court (Defence and Counterclaim), the Trustee required, inter alia:

A. A declaration that Company A has a % interest in the Trust Fund including in any undistributed income of the Unit Trust.

D. …an order that the Trustee is entitled to be indemnified out of the assets of the Trust Fund against liabilities incurred by it on the execution or as a consequence of the failure to exercise any of the trust authorities, powers and discretions in the Unit Trust Deed or by virtue of being the trustee of the Unit Trust.

G. Costs

H. Such further or other order as the Court deems appropriate.

Settlement

13. In late 2014 the non-resident beneficiaries and the Trustee (with other parties) entered into a Deed of Settlement and Release (Deed) which stated, in part, that;

Recitals

….

E. To avoid the costs, inconvenience and uncertainty of litigation, the Parties have agreed to settle the Supreme Court Proceeding, including the Counterclaim, on the terms set out in this Deed, without any admission of liability.

OPERATIVE PROVISIONS

1. DEFINITION AND INTERPRETATION

1.1 In this deed, unless the context requires otherwise:

(a) Claims includes any claim, notice, demand, costs (including legal costs and expenses), debts, dues, liabilities, distribution, damages, losses, action, proceeding, litigation, investigation or judgment, however, it arises, present or future, fixed or unascertained, actual or contingent.

….

2. RECITALS FORM PART OF THESE TERMS

2.1 The Parties to this Deed agree that the Recitals are correct and form part of the Deed.

3. SETTLEMENT

3.1 The Trustee agrees to pay Company A the Sum of $X (Settlement Sum) in full and final settlement of the Supreme Court proceedings as follows:

(a) subject to Company A providing a release of caveats, on properties that were subject to contracts of sale; and

(b) within 90 days of the date of the execution of this Deed, the balance of the Settlement Sum less the payment made in accordance with subparagraph (a) above).

3.3 Company A, and the other non-resident beneficiaries agree that Company A will pay the other non-resident beneficiaries the following amounts out of the Settlement Sum:

(a) Individual B - $Y;

(b) Individual C - $Z

4. SUPREME COURT PROCEEDING

4.1 Within 7 days of execution of the Deed, the Parties agree to execute and file consent orders dismissing the entirety of the Supreme Court proceeding with a right of reinstatement, with no orders as to costs.

5. THE UNIT TRUST

5.1 Upon payment of the full Settlement Sum by payment of cleared funds, the Parties agree that all of the non-resident beneficiaries units in the Unit Trust shall be cancelled, and shall execute all documents and take all steps necessary to give effect to cancellation of the units.

8. RELEASE

8.1 Upon execution of this Deed, all non-resident beneficiaries release and forever discharge the Trustee from any and all Claims related to, arising out of, or in connection with, their dealings whatsoever with the Trustee, including any and all Claims relating to the Unit Trust, the entire subject matter of the Supreme Court proceedings and all matters that directly and /or indirectly touch and concern the subject matter of the Supreme Court Proceeding (the non-resident beneficiaries Release).

8.2 Upon execution of this Deed, the Trustee release and forever discharge all non-resident beneficiaries from any and all Claims related to, arising out of, or in connection with, their dealings whatsoever with all non-resident beneficiaries, including any and all Claims relating to the Unit Trust, the entire subject matter of the Supreme Court proceedings and all matters that directly and /or indirectly touch and concern the subject matter of the Supreme Court Proceeding (the Trustee Release).

13. TAX, GST

13.1 Any payment made pursuant to this Deed is expressed as a gross amount, which is inclusive of any tax on the payment. Each party will bear its own tax obligations in respect of the receipt of any payment pursuant to this Deed.

13.2 All non-resident beneficiaries agree to indemnify the Trustee in respect of any tax obligations (including any requirement to pay withholding tax) that may be incurred by it in respect of the payment of Settlement Sum to Company A.

13.3 Any amount stated in this Deed has been determined inclusive of any application of GST.

14. COSTS

14.1 Each party agrees to bear their own costs and expenses of and incidental to the negotiation, preparation, completion and execution of this Deed.

16. ENTIRE AGREEMENT

16.1 This Deed constitutes the entire agreement of the Parties about its subject matter and supersedes all previous agreements, understandings and negotiations on that subject matter.

Retention of amount by the Trustee

14. According to the ruling application:

The trustee notified the non-residents, that it was treating the payment of the Settlement Sum as a distribution of Trust income with the consequence that tax was payable on the payment….

15. Tax was withheld from the payment at a flat rate % in relation to the portion attributable to the non-resident company, and a flat rate of % in relation to the portion attributable to the non-resident individuals.

16. The ruling application further states that:

By letter dated, the non-resident beneficiaries notified the Trustee that they did not agree with the trustee's assessment of the tax position and notified the trustee that they considered the settlement sum to be payment in the nature of damages and, accordingly, no tax was payable.

On, Company A commenced a proceeding against the Trustee seeking payment of the full settlement sum….

….

The Trustee is concerned to ensure that it complies with any obligations in relation to tax in relation to the payment of the settlement sun under the Settlement Deed and seeks a ruling from the ATO on the questions raised. It requests that any ruling be independent of any position taken by the parties in the litigation. Those matters are brought to the Commissioner's attention by way of background…..

17. In an Outline of Plaintiff's Reply Submissions made to the Supreme Court (Reply Submissions), the legal representatives for the non-resident beneficiaries states at paragraph 12 that:

The Settlement Sum is an un-dissected amount and represents a payment of damages, and in accordance with relevant authorities the payment of the Settlement Sum does not constitute income in the hands of Company A.

18. In paragraph 15 of the Reply Submissions, it is further stated that:

…there is no basis for dissection or apportionment of the Settlement Sum which allows for those monies in part or wholly to be characterised as income in the hands of our client.

19. In the Outline of Plaintiff's Reply Submissions, reliance is placed on the decision in FC of T v Spedley Securities (1989) 19 ATR 938 to support the above contention.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 98(2A)

Income Tax Assessment Act 1936 Subsection 98(3)

Income Tax Assessment Act 1936 Section 95

Income Tax Assessment Act 1936 Subsection 254(1)

Income Tax Assessment Act 1936 Subsection 255(1)

Income Tax Assessment Act 1997 104-25

Income Tax Assessment Act 1997 Section 118-20

Income Tax Rates Act 1986 Schedule 7

Reasons for decision

Summary

20. The trustee is liable to pay income tax pursuant to subsections 98(2A) and subsection 98(3) of the Income Tax Assessment Act 1936 (ITAA 1936) on the Settlement Sum paid to the non-resident beneficiaries in the year ended 30 June 2015.

21. The rates of tax payable in relation to this income are determined pursuant to subsection 98(3), and the Income Tax Rates Act 1986.

Detailed Reasons

THE LAW

22. Pursuant to subsection 98(2A) of the ITAA 1936:

If:

(a) a beneficiary of a trust estate who is presently entitled to a share of the income of the trust estate:

(i) is a non-resident at the end of the year of income; and

(ii) is not, in respect of that share of the income of the trust estate, a beneficiary in the capacity of a trustee of another trust estate; and

(i) is not a beneficiary to whom section 97A applies in relation to the year of income; and

(ii) is not a beneficiary to whom subsection 97(3) applies; and

(b) the trustee of the trust estate is not assessed and is not liable to pay tax under subsection (1) or (2) in respect of any part of that share of the net income of the trust estate;

subsection (3) applies to the trustee in respect of:

(c) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and

(d) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

23. Subsection 98(3) of the ITAA 1936 states that:

A trustee to whom this subsection applies in respect of an amount of net income is to be assessed and is liable to pay tax:

(a) if the beneficiary is not a company - in respect of the amount of net income as if it were the income of an individual and were not subject to any deduction; or

(b) if the beneficiary is a company - in respect of the amount of net income at the rate declared by the Parliament for the purposes of this paragraph.

24. According to section 95 of the ITAA 1936:

net income, in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus.

25. In part, subsection 254(1) of the ITAA 1936 states that:

With respect to every agent and with respect also to every trustee, the following provisions shall apply:

….

(d) He or she is hereby authorized and required to retain from time to time out of any money which comes to him or her in his or her representative capacity so much as is sufficient to pay tax which is or will become due in respect of the income, profits or gains.

26. Further, subsection 255(1) of the ITAA 1936 states that:

With respect to every person having the receipt control or disposal of money belonging to a non-resident, who derives income, or profits or gains of a capital nature, from a source in Australia or who is a shareholder, debenture holder, or depositor in a company deriving income, or profits or gains of a capital nature, from a source in Australia, the following provisions shall, subject to this Act, apply:

(a) the person shall when required by the Commissioner pay the tax due and payable by the non-resident;

(b) the person is hereby authorized and required to retain from time to time out of any money which comes to the person on behalf of the non-resident so much as is sufficient to pay the tax which is or will become due by the non-resident;

(c) the person is hereby made personally liable for the tax payable by the person on behalf of the non-resident to the extent of any amount that the person has retained, or should have retained, under paragraph (b); but the person shall not be otherwise personally liable for the tax;

(d) the person is hereby indemnified for all payments which the person makes in pursuance of this Act or of any requirement of the Commissioner.

27. This does not constitute a 'withholding tax', but simply a retention of sufficient funds to pay any expected taxation liability.

28. Based on the information provided in the ruling application, any profits from the property development are Australian-sourced, and the payment was made to a company and other individuals who were non-resident beneficiaries in the relevant income year for Australian domestic taxation purposes.

29. Thus, provided the Settlement Sum is wholly assessable income, the Trustee is:

• assessed on the Settlement Sum amount paid to the non-resident beneficiaries; and

• is required to retain money sufficient to pay the resultant income tax liability.

Is any or all of the payment assessable income?

30. Based on the decisions in McLaurin v. Commissioner of Taxation [1961] HCA 9; (1961) 104 CLR 381 and Allsop v. Commissioner of Taxation [1965] HCA 48; (1965) 113 CLR 341, it is accepted that a settlement payment made to compensate for losses of both an income and capital nature will be wholly treated as being capital in nature where it is paid as an undissected lump sum, such that the income and capital components of the payment are not capable of being identified and quantified.

31. In this current case, where the Settlement Sum was held to be an undissected lump sum payment, no income tax would be payable, and thus the trustee could have no income tax obligations in relation to this particular payment.

32. It must be considered, however, whether the Settlement Sum was paid, in whole or in part, as a substitute for the profit to which the taxpayer was entitled in relation to their investment in the Trustee.

Is the Settlement Sum a substitute for income?

33. As stated by Fullager J at paragraph 7 in FC of T v Dixon (1952) 86 CLR 540; [1952] HCA 65:

The payments made by way of "compensation" were held to partake of the same nature as the payments which would have been made if the employment of Phillips had continued….In a joint judgment Dixon and Evatt JJ. said:- "No prima facie reason exists for regarding as instalments of capital annual payments which are taken in place of the contractual rights" (1936) 55 CLR, at p 156 given by the original contract. And again:- "In these circumstances they" (i.e. the payments under the substituted contract) "must . . . be regarded as of the same nature as the payments they replace" (1936) 55 CLR, at p 157.
(at p569)

34. Thus, the ATO view in TD 93/58 in relation to a settlement/compensation payment is that:

It is assessable income under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA) [now section 6-5 of the ITAA 1997]:

(a) if the 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 [cf. Mc Laurin v. FC of T (1961) 104 CLR 381; (1961) 8 AITR 180 and Allsop v. FC of T (1965) 113 CLR 341; (1965) 9 AITR 724].

35. According to clause 3.1 of the Deed, the Settlement Sum was intended to be paid '…in full and final settlement of the Supreme Court proceedings.'

36. The Deed does not identify any heads of claim to which any specific part of the Settlement Sum relates.

37. However, based on the Amended Statement of Claim and Defence and Counterclaim filed in relation to the dispute between the Trustee and the non-resident beneficiaries, the dispute and the compensation sought by the non-resident beneficiaries related to a share of the profits derived by the Trustee from the property development.

38. Further, there does not appear to have been any dispute between the parties to the proceeding that the non-resident beneficiaries had an entitlement to a share of the profits from the property development and sale undertaken by the Trust.

39. Indeed, pursuant to clause 3.1 of the Deed, part of the Settlement Deed was specifically to be paid by the Trustee out of the '…net proceeds after all costs and expenses...' from the sale of the apartments.

40. It is considered that compensation based on a share of profits would be in substitution for losses of an income nature.

41. Thus, it is necessary to consider if the Settlement Sum was paid as '…compensation for loss of income only e.g. past year profits, and/or interest…' or whether at least part of the Settlement Sum was for a loss of a capital nature, such that the Settlement Sum was an undissected lump sum.

Spedley Securities

42. In the Reply Submissions document filed on behalf of Company A by their legal representative, considerable reliance was placed on the precedent established in FC of T v Spedley [1988] FCA 31; 88 ATC 4126 (Spedley).

43. In their joint judgment in Spedley, the Full Court considered the nature of an undissected compensation payment made for termination of an agreement, and particularly the contention outlined at paragraph 16 that:

…as a matter of analysis of the facts before the Tribunal it is quite obvious that the amount must have represented part of [an] agreed commission.

44. However, in responding to this contention, the Full Court stated at paragraph 16 that:

We do not find this assertion at all convincing. The most that can be said is that quite possibly some part of the agreed commission played a part in arriving at the figure of $200,000.

45. The Full Court therefore determined in Spedley that the payment was not assessable, being of a capital nature.

46. On the basis of this reasoning in Spedley, it was contended by the representatives for the non-resident beneficiaries that the Settlement Sum could not be characterised as being income in nature.

47. However, there was a considerable factual difference between the Settlement Sum currently under consideration and that which was considered in Spedley. In particular, the Full Court identified a specific and significant right of a capital nature for which the taxpayer appeared to have been compensated. It is stated further at paragraph 16 in Spedley that:

There was…evidence of concern by Spedley's principals for its reputation in the international money market. It had been formed for only two years and this was its largest endeavour. It seems to us to be perfectly reasonable that a main concern was its international (as well as its national) standing.

48. It is further stated in paragraph 18 of the judgment that:

There was therefore evidence upon which the Tribunal could hold that the payment was, at least in a substantial part, recompense for damage to its reputation. (emphasis added)

49. For example, the Administrative Appeals Tribunal had earlier:

…found that Mr Yuill, the Managing director of Spedley, had informed Mr Bond that according to legal advice the former had received, Spedley's most substantial claim against Santos would be for damage to its reputation and goodwill and that his would be the primary ground of relief in any proceedings taken. (at paragraph 16)

50. It was thus concluded by the Full Court at paragraph 20 that:

In the present case the amount received comprised or included recompense for damage to goodwill, which, it is agreed, is an item of capital.

51. However, the Full Court subsequently distinguished the decision in Spedley when delivering their joint judgment in Allied Mills Industries Pty Ltd v FC of T (1989) 20 FCR 288; [1989] FCA 110; 89 ATC 4365; 20 ATR 457.

52. Indeed, the Full Court specifically noted at paragraph 39 that:

In Spedley this Court approached the matter on the basis that, as the Administrative Appeals Tribunal, from whose decision the appeal was brought to this Court, had found that the receipt was a lump sum which was at least in a substantial part compensation for injury to a capital asset, namely, goodwill, and, as the parties had agreed that this was an item of capital, what was received was not capable of dissection or apportionment.

53. Distinguishing the decision in Spedley from the circumstances of Allied Mills, the Full Court then stated at paragraph 40 that:

In the present case there was a single payment of $372,700. Although the sum was paid and received as compensation for termination of the appellant's sole distributorship and its residual contingent manufacturing rights with respect to Vita Wheat we do not regard it as a payment of a mixed nature capable of apportionment in the sense in which McLaurin, Allsop and Spedley speak. The residual manufacturing rights were elements in the sole distributorship of the appellant or ancillary to it. There was a single payment received in compensation for the termination of the arrangements between the appellant and Arnotts which is properly characterised as a payment for the loss of profits caused by the termination.

Application to rulee

54. According to subclause 3.1 of the Deed, the payment of the Settlement Sum was made '…in full and final settlement of the Supreme Court Proceedings…'.

55. However, based on a review of the Amended Statement of Claim and Defence and Counterclaim in relation to these proceedings, there are no identifiable rights of a capital nature, such as damages to reputation or goodwill, for which the non-resident beneficiaries were seeking compensation.

56. Rather, as in Allied Mills, the identifiable element for which the non-residents beneficiaries considered they were required to be compensated was related to profit.

Release from 'any and all Claims'

57. Based on the Defence and Counterclaim document, in 2012, the Trustee returned to the non-resident beneficiaries the capital which they had originally invested in the Trustee.

58. Based on the ruling application, legal proceedings were not instituted by the non-resident beneficiaries until 2013.

59. Thus, other than the claim for a portion of the '…undistributed income of the Trust…', the only other claim for monetary compensation made by Company A in the Amended Statement of Claim was for 'Costs'. Indeed, both the Amended Statement of Claim filed on behalf of the non-resident beneficiaries and the Defence and Counterclaim file on behalf of the Trustee include a claim for 'Costs' in relation to the ongoing dispute between the parties.

60. Subclause 4.1 of the Deed states that:

Within 7 days of execution of the Deed, the Parties agree to execute and file consent orders dismissing the entirety of the Supreme Court Proceeding with a right of reinstatement, with no orders as to costs.

61. The legal costs incurred by both parties to the Deed are dealt with under Clause 8 of the Deed, which states that:

8.1 Upon execution of this Deed, the non-resident beneficiaries release and forever discharge the Trustee from any and all Claims related to, arising out of, or in connection with, their dealings whatsoever with the Trustee, including any and all Claims relating to the Unit Trust, the entire subject matter of the Supreme Court Proceeding and all matters that directly and /or indirectly touch and concern the subject matter of the Supreme Court Proceeding.

8.2 Upon execution of this Deed, the Trustee release and forever discharge the non-resident beneficiaries from any and all Claims related to, arising out of, or in connection with, their dealings whatsoever with the non-resident beneficiaries, including any and all Claims relating to the Unit Trust, the entire subject matter of the Supreme Court Proceeding and all matters that directly and /or indirectly touch and concern the subject matter of the Supreme Court Proceeding.

62. Pursuant to subclause 1.1:

In this Deed, unless the context requires otherwise:

(a) Claims includes any claim, notice, demand, costs (including legal costs and expenses), debts, dues, liabilities, distribution, damages, losses, action, proceeding, litigation, investigation or judgment, however, it arises, present or future, fixed or unascertained, actual or contingent. (emphasis added)

63. The wording of the Deed would not exclude compensation for the non-resident beneficiaries legal costs from forming part of the Settlement Sum.

64. However, as:

• Clause 8 is based on a mutual release of claims, including claims for legal costs and expenses;

• there was no order as to liability for legal costs and expenses; and

• the Deed does not provide any compensation to the Trustee in relation to their legal costs

there is no basis for concluding that the Settlement Sum contained unilateral compensation to Company A for their particular legal costs and expenses.

65. Equally, pursuant to Clause 8, the opposing parties to the settlement have mutually agreed to '…release and forever discharge…' each other from:

…any and all Claims related to, arising out of, or in connection with, their dealings whatsoever…relating to the Unit Trust, the entire subject matter of the Supreme Court Proceeding and all matters that directly and /or indirectly touch and concern the subject matter of the Supreme Court Proceeding… (emphasis added)

66. Thus, it is arguable that the consideration received by the non-resident beneficiaries from the release and discharge of 'any and all Claims…' in relation to the Proceedings was the agreement by the Trustee and the other parties to equally release and discharge any claims arising out of the Proceedings.

67. Further, Subclause 14.1 of the Deed states that:

Each party agrees to bear their own costs and expenses of and incidental to the negotiation, preparation, completion and execution of this Deed.

68. Thus, the Settlement Sum could not include any compensation to Company A for the costs specifically in relation to the settlement process itself.

ATOID 2003/707 and Sommer

69. In the Deed, each party agreed to '…release and forever discharge…' each other '…from any and all Claims related to… their dealings whatsoever…' (emphasis added).

70. ATO Interpretative Decision 2003/707 Income Tax Assessability of an undissected lump sum workers compensation payment is concerned with a lump sum commutation payment made not only in respect of a taxpayer's right to 'weekly workers compensation and medical expenses', but '…in full and final satisfaction of all present and future claims against their employer.'

71. The ATO view expressed in this ATO ID is that:

In this instance, the settlement offer of a lump sum payment has been made to replace an income stream, medical expenses and a capital asset.

….

The settlement offer was made to redeem the taxpayer's entitlement to weekly compensation payments and medical expenses and to surrender their rights to any other future claim against their employer. There will be no identifiable or quantifiable component of the proposed lump sum payment. (emphasis added)

As the proposed 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 whole amount would be deemed to be of a capital nature. Therefore, the lump sum amount is not assessable income under section 6-5 of the ITAA 1997.

72. However, this ATO view is not consistent with the earlier Federal Court decision in Sommer v. FC of T [2002] FCA 1205; 2002 ATC 4815; 51 ATR 102 (Sommer). In Sommer, a settlement lump sum payment made to a taxpayer in relation to an income replacement insurance policy was held to be assessable income, notwithstanding that, under the terms of the settlement, the taxpayer surrendered '…all further rights under the policy.'

73. The taxpayer in Sommer:

…argued before the AAT that the settlement amount was a payment of capital as it was paid in consideration of the cancellation of the policy and the consequential surrender by the applicant of all further rights under the policy. The applicant also argued that, even if part of the consideration was paid in settlement of the applicant's income replacement claim, the lump sum payment received on settlement represented an undissected aggregation of both income and capital components with the consequence that the entire sum is on capital account. (at 4817)

74. In response, Merkel J stated at 4818 that:

In the present case the terms of the agreement refer to the relevant surrounding circumstances…. Accordingly, it is difficult for the applicant to argue that the surrounding circumstances are not relevant to the characterisation of the settlement amount. In my view, the true nature and proper characterisation of the settlement amount is to be determined by having regard to the policy, the applicant's claims under the policy, the terms of settlement which, inter alia, settled those claims and the rights the applicant will be surrendering upon the cancellation of the policy.

75. He then further stated that:

The only claim made by the applicant was for income replacement benefits of $4,000 per month payable as from August 1996. That claim, which was for past and future benefits, was settled by the terms of settlement. Two aspects of the terms confirm that that is so. The first is that the proceeding in which the claim is made is to be dismissed upon payment of the settlement amount (see cl 5). The second is that it appears to have been the clear intention and agreement of the parties that, as a result of the cancellation of the policy, the applicant was not entitled to receive any further benefits under the policy (see cll 1 and 3), which benefits included the past and future benefits he had claimed. The applicant had not made or threatened to make any other claims under the policy. Thus, it is clear from the terms of settlement and the claims settled by those terms that the fundamental element in the payment of the settlement amount was that it settled the past and future income replacement claims of the applicant.

76. On this basis, it was concluded by Merkel J at 4819 that:

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.

Application to current taxpayer

77. It is acknowledged that the non-resident beneficiaries were not seeking a settlement in relation to an income replacement insurance policy. However, it is considered that the principles established by the Federal Court in Sommer can be applied to the circumstances of these beneficiaries.

78. In the current case the '…substance and the commercial reality of the settlement…' was the satisfaction of the non-resident beneficiaries right to a share of the profits from the property development and sale undertaken by the Trust in which they held units.

79. Thus, it is considered that the Settlement Sum is wholly assessable as income.

Summary

80. It is considered that the Settlement Sum paid was solely intended to compensate for entitlements of an income nature, and in particular, to compensate for the taxpayer's undisputed entitlement to a share of profits from their investment in the Trustee. No losses of a capital nature have been identified for which the compensation amount could have been wholly or partly paid.

81. Thus, the Settlement Sum paid in compensation for these entitlements is fully assessable as income.

Is the Settlement Sum income and net income of the trust estate?

82. In order for subsections 98(2A) and 98(3) to apply, it is not sufficient that the Settlement Sum be assessable as income. The trustee of a trust estate is only liable to pay income where a non-resident beneficiary who is '…presently entitled to a share of the income of the trust estate…' is in receipt of a share of '…the net income of the trust estate'.

83. Thus, the Settlement Sum must form part both of 'the income of the trust estate' and 'the net income of the trust estate'.

84. According to the decision in the decision in Zeta Force Pty Ltd v. FC of T (1998) 84 FCR 70; [1998] FCA 728; 98 ATC 4681; (1998) 39 ATR 277 as cited with favour by the High Court in FC of T v. Bamford [2010] HCA 10; 2010 ATC 20-170; (2010) 75 ATR 1:

The words 'income of the trust estate' in the opening part of s 97(1) refer to distributable income, that is to say income ascertained by the trustee according to appropriate accounting principles and the trust instrument. That the words have this meaning is confirmed by the use elsewhere in Div 6 of the contrasting expression 'net income of the trust estate'. The beneficiary's 'share' is his share of the distributable income."

85. Pursuant to section 95:

…net income, in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus.

86. On the basis that the returns made by the Trust from the property development were on revenue rather than capital account, they would form part of both the income of the trust estate and net income of the trust, being both:

…income ascertained by the trustee according to appropriate accounting principles and the trust instrument…; and

…assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions…

87. Based on the ruling application, given the earlier repayment of the capital investment made by unit holders in the trust, the source of the payment to the non-resident beneficiaries was the profit from the property development undertaken by the Trust.

88. As unit holders in the Trust, the non-resident beneficiaries had an entitlement to the income of the Trust, including income during the 2015 income year in which the settlement was entered into.

89. Thus, to the extent that the non-resident beneficiaries were presently entitled to a share of the income of the trust estate, the Trustee was assessable under subsection 98(3) to the extent of each non-resident beneficiaries' share of the net income of the trust estate.

90. Equally, to the extent that the Trustee was liable to be assessed under subsection 98(3) in relation to these shares of the net income of the trust estate, pursuant to sections 254, they were also:

…authorized and required to retain from time to time out of any money which comes to him or her in his or her representative capacity so much as is sufficient to pay tax which is or will become due in respect of the income, profits or gains.

91. As the Settlement Sum represents payments by the Trustee out of the profits from the property development undertaken by the Trust in satisfaction of the non-resident beneficiaries rights as unit holders in the Trust, the Trustee in their 'representative capacity' as trustee were required to retain sufficient funds to pay tax which will become payable in respect of those profits.

92. The Trustee determined the amount which they would be required to retain based on the amount of the Settlement Sum.

Capital gain

93. It is arguable that CGT event C2 may happen on the satisfaction of the taxpayer's contended right to compensation through the entering into of the Deed and receipt of the Settlement Sum.

94. If this were the case, the taxpayer would make a capital gain based on the difference between the Settlement Sum and the cost base of the right.

95. Section 255 requires a trustee to retain sufficient funds to meet any liability of the trustee in relation to gains of a capital nature made by a non-resident from a source in Australia.

96. However, pursuant to section 118-20, any capital gain made would be reduced to the extent that the amount is assessable under another provision of the ITAA 1997. As the Settlement Sum received by the non-resident beneficiaries is considered to form part of the net income of the Trust as Australian-sourced income of a non-resident, it will not also be included in determining any net capital gain or loss made by the non-resident beneficiaries for the relevant income year.

How much is the trustee obligated to pay/withhold by way of tax on the settlement sum?"

THE LAW

97. Pursuant to subsection 98(3):

A trustee to whom this subsection [98(2A)] applies in respect of an amount of net income is to be assessed and is liable to pay tax:

(a) if the beneficiary is not a company - in respect of the amount of net income as if it were the income of an individual and were not subject to any deduction; or

(b) if the beneficiary is a company - in respect of the amount of net income at the rate declared by the Parliament for the purposes of this paragraph.

98. The Settlement Sum was paid in instalments in the year ended 30 June 2015. The company tax rate for this year was %.

99. In respect of the individual non-resident beneficiaries, the rate of tax for the year ended 30 June 2015 income year pursuant to Schedule 7 of the Income Tax Rates Act 1986 was:

Tax rates 2014-15
Share of net income	Tax on this income
0 - $80,000	32.5c for each $1
$80,001 - $180,000	$26,000 plus 37c for each $1 over $80,000
$180,001 and over	$63,000 plus 45c for each $1 over $180,000

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