Edited version of your written advice

Authorisation Number: 1013040675108

Date of advice: 13 July 2016

Ruling

Subject: Lump sum payment

Question 1

Is the lump sum payment regarded as ordinary assessable income?

Answer

No.

Question 2

Is the lump sum payment assessable under the capital gains tax provisions?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2016

The scheme commences on:

1 July 2015

Relevant facts and circumstances

You were employed.

You lodged a compensation claim which was rejected on the basis that the injury did not arise from your employment.

You lodged a Notice of Dispute in the Tribunal, disputing the rejection of your claim.

Your employer's insurer considered that a pragmatic settlement would be a good outcome in this matter and ongoing disputation may jeopardise the relationship with your employer.

In order to settle the matter without going to court your employer's insurer has offered you an ex-gratia payment of $XXXXX, upon you agreeing that the insurer has no liability for weekly payments or payment of medical expenses, essentially giving up your right to sue.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5(2)

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 118-37(1)

Reasons for decision

Summary

Your un-dissected lump sum is not regarded as ordinary assessable income, however no exemption from capital gains tax applies and the capital payment is assessable under the capital gains tax provisions.

Detailed reasoning

Ordinary Income

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.

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:

• are earned.

• are expected

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

Payments of salary and wages are income according to ordinary concepts and are included in your assessable income.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443;10 ATD 82). Compensation payments which substitute income have been held by the courts to be income according to ordinary concepts (FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

Lump sum payments

Taxation Determination TD 93/58 outlines the circumstances under which the receipt of a lump sum compensation/settlement payment is assessable as ordinary income.

The determination states that where the compensation payment is for loss of income, the amount is assessable as ordinary income. Where a portion of a lump sum payment is identifiable and quantifiable as income, that portion of the payment will be assessable.

This view was subsequently confirmed in Sommer v. FC of T 2002 ATC 4815; 51 ATR 102 (Sommer's case). The case involved a medical practitioner who had taken out an income protection policy. Following the rejection of the taxpayer's claim for income replacement payments of $4,000 per month, the matter was settled out of court with the taxpayer receiving a lump sum. The taxpayer argued that the amount was a payment of capital as it was paid in the consideration of the cancellation of the policy, and the surrender of his rights under it or that the payment was capital as it was an un-dissected aggregation of both income and capital.

In dismissing the taxpayer's appeal it was held that the payment was in settlement of 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 on a revenue account. The fact that the payment was received in one lump sum did not change its revenue character.

In your case you were making a claim for workers' compensation. You have now been offered a lump sum payment to give up your claim for workers compensation with your employer's insurer.

The lump sum settlement to be received does not relate to personal services, property, or the carrying on of a business. The payment is also a one-off payment and thus does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from the performance of personal services. In your circumstances, the lump sum payment is not ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income and are also included in assessable income.

Amounts received as a lump sum are generally capital in nature and are potentially taxable as statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

Capital gains

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.

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 ITA 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.

These provisions would have clear and direct application in relation to an insurance policy against a specific injury or illness. For example, trauma insurance that pays a lump sum if the person loses a limb or suffers a heart attack. Such a payment would be disregarded for CGT purposes under section 118-37 of the ITAA 1997.

However, the application of section 118-37 of the ITAA 1997 in relation to settling a workers' compensation claim may be more problematic.

In the case of Purvis v. FC of T [2013] AATA 58 (Purvis' case), the Administrative Appeal Tribunal considered the tax consequences of a 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 paragraph 118-37(1)(b) of the ITAA 1997. 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.

In cases where a dispute between a workers' compensation insurer and an employee is settled by way of the former making a lump sum payment to the latter; it would presumably be the case that the payment is intended to compensate the employee for the loss of entitlements under workers' compensation, rather than to compensate the person for their injury or illness as such.

Where compensation is intended to remedy damage to an asset, taxing of that compensation may prevent the remedy occurring. For example, if you incur $1,000 damage to your car and receive $1,000 in compensation, paying tax on that amount would frustrate the purpose of the compensation. For this reason, it is sometimes necessary to identify the damaged underlying asset that the compensation was intended to remedy, and to consider the capital gains tax consequences of the compensation in relation to that asset.

Taxing the compensation for the giving up of an income stream does not create this issue, as the income stream would have itself been taxable. Taxing compensation intended to cover medical benefits, however, may frustrate the purpose of the compensation. In these circumstances it may be appropriate to take a concessional approach and concede that compensation for the payment of medical costs are sufficiently related to personal illness or injury to be exempt from capital gains under paragraph 118-37(1)(b) of the ITAA 1997.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts outlines when it may be relevant to consider the compensation in the context of an underlying asset.

Primarily the settlement of a dispute involving a workers' compensation claim would amount to the disposal of a right to seek compensation. However, underlying this is the forfeiture of your rights under workers' compensation - in most cases, this would predominantly involve forfeiting the right to receive an income stream; but in some cases, there may also be subsidiary benefits at issue.

If the compensation is received in relation to multiple heads of claim, TR 95/35 allows a reasonable apportionment of that payment. For example, if a payment is intended to replace both an income stream and other potential benefit entitlements, the payment may be apportioned between the two heads of claim on a reasonable basis. However, if the payment is truly an un-dissected lump sum - that is, no reasonable apportionment can be made between the multiple heads of claim - no exemption can be applied unless you are able to prove that the amount received was solely for personal injury.

This approach was confirmed in Dibb v. Commissioner of Taxation [2004] FCAFC 126 which found that no part of a genuinely un-dissected lump sum could be said to be paid in relation to personal injury. The exemptions in paragraphs 118-37(1)(a) and (b) of the ITAA 1997 cannot apply if the compensation amount is received as a lump sum (and that lump sum is truly un-dissected) but there were rights to income type payments as well as rights relating to personal injury that are extinguished in the settlement.

Application to your circumstances

Your lump sum settlement is more than a straight income replacement and includes potential capital benefits such as incapacity, medical and rehabilitation payments. It is therefore accepted that the payment is an un-dissected settlement amount and that the lump sum payment is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Acceptance of the lump sum is considered to be a payment for the ending of your claim for workers' compensation. This gives rise to CGT event C2. Your payment cannot be said to be for a single defined payment for an injury.

As was the case in Sommer's case and Purvis' case, although your compensation may have been triggered by a personal injury, the actual lump sum payment is not a personal injury payment. The payment covers a loss of various rights and entitlements, including a loss of income. Therefore the lump sum payment is assessable as a capital gain and the exemption contained in section 118-37 of the ITAA 1997 cannot apply.

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