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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your written advice

Authorisation Number: 1013034094571

Date of advice: 15 June 2016

Ruling

Subject: Settlement payment

Question 1

Is the settlement payment you received assessable income?

Answer

No.

Question 2

Will any capital gain arising from the lump sum compensation payment be disregarded?

Answer

Yes.

Question 3

Are you entitled to a deduction for the legal expenses incurred?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20YY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Your employment was terminated following an incident at your workplace.

You commenced proceedings against your employer alleging breaches of the Fair Work Act.

You agreed to settle the proceedings.

You received a settlement sum.

The settlement amount was comprised of general and aggravated damages and was not for lost income.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 118-37

Reasons for decision

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

Other characteristics of income that have evolved from case law include receipts that:

The compensation offered to you is not income from rendering personal services, income from property or income from carrying on a business.

The payment is also a one off payment and thus it does not have an element of recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. 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.

Your settlement is a result of legal action where you sought general and aggravated damages following an incident at your workplace. It is not a lump sum payment which substitutes for an income stream. The lump sum payment is a capital receipt and is not ordinary income. Therefore the amount is not assessable under section 6-5 of the ITAA 1997.

Capital Gain

Part 3-1 contains the capital gains and capital loss provisions commonly referred to as the CGT provisions. You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation, that is, the right to take legal action. The lump sum amount you will receive will be capital proceeds for this CGT event and a capital gain will usually arise.

The net capital gain you make is then included in your assessable income under section 102-5 of the ITAA 1997 unless an exemption applies.

CGT Exemption

Paragraph 118-37(1)(a) of the ITAA 1997 allows a capital gain to be disregarded if it is compensation or damages you receive for any wrong or injury you suffer in your occupation.

Paragraph 118-37(1)(b) of the ITAA 1997 allows a capital gain to be disregarded if it is compensation or damages you receive for any wrong, injury or illness you suffer personally.

Taxation Ruling TR 95/35 deals with the capital gains treatment of compensation receipts. TR 95/35 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.

Paragraphs 296 to 304 of TR 95/35 provide a number of examples where taxpayers seek compensation for personal wrong injury or illness and even though the relevant CGT asset is the right to seek compensation, using the 'look-through' approach the compensation amount is exempted under subsection 160ZB(1) of the Income Tax Assessment Act 1936. Paragraph 118-37(1)(b) of the ITAA 1997 replaced subsection 160ZB(1) of the Income Tax Assessment Act 1936 from 1 July 2006.

Applying paragraph 118-37(1)(b) of the ITAA 1997 to your circumstances, the lump sum payment would not be considered as an assessable capital gain.

Legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of assessable income. 

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. 

If the advantage is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in the assessable income of the taxpayer. 

Application to your circumstances

Your lump sum settlement is capital receipt and is not assessable under section 6-5 of the ITAA 1997.

Acceptance of the lump sum is considered to be a payment for the ending of your rights to further action following the incidents that lead to the proceedings. This gives rise to CGT event C2.

The lump sum payment was received as a result of the wrong or injury that you suffered. Therefore, applying paragraph 118-37(1)(b) of the ITAA 1997 to your circumstances, the lump sum payment will not be assessable as a capital gain.

As the payment is not assessable as either ordinary income or as a capital gain, it will not be included as part of your assessable income.

Additionally, as the payment you received is capital in nature, the expenses incurred in securing that payment are also capital in nature. Consequently, no deduction is allowable under section 8-1 of the ITAA 1997 for the legal expenses you incurred as expenditure of a capital nature is expressly excluded.

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