Edited version of your written advice

Authorisation Number: 1013117221436

Date of advice: 1 November 2016

Ruling

Subject: Assessability of a lump sum compensation payment

Question

Will the lump sum payment that you receive from an income protection policy be included in your assessable income in the income year in which the payment is made?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commenced on

1 July 20XY

Relevant facts

You held an income protection policy.

A number of years later you sustained a serious injury while conducting your employment duties.

As a result of your injury you received monthly payments from your insurer.

After a number of years your insurer ceased making any further payments.

After the cessation of monthly payments you entered into a legal dispute with your insurer for continuance of the monthly payments.

You have received a proposed settlement.

You have provided a copy of the 'Deed of release' that will be read with this ruling.

You have been informed by your doctor that you will never be able to return to work.

Relevant legislative provisions

Income Tax Assessment Act 1997, Section 6-5

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.

Ordinary income has generally been held to include 3 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 assessable income under section 6-5 of the ITAA 1997.

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 under ordinary concepts (FC of T v. Inkster (1989) 20 ATR 1516; 89 ATC 5142; Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641; Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

Therefore periodic payments received during a period of total or partial disability under an income protection policy are assessable on the same principle as salary and wages. This is because the benefits are a replacement of employment income during the period of total or partial disability (FC of T v. D.P. Smith 81 ATC 4114; (1981)11 ATR 538).

Although a lump sum payment under a personal accident, income protection or disability insurance policy is not a periodic payment; the above principle may also apply to a lump sum paid to settle all outstanding claims under the policy. To determine the character of such a lump sum, it is necessary to consider the terms of the particular policy and the reason for making the payment.

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable?, discusses the Commissioner's view of the circumstances in which a lump sum compensation / settlement payment is assessable.

Paragraph 1 of Taxation Determination TD 93/58 states:

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].

It is well established that, in general, insurance moneys are received on revenue account where the purpose of the insurance was to fill the place of the revenue receipt which the event insured against has prevented from arising (Carapark Holdings Ltd v. Federal Commissioner of Taxation (1967) 115 CLR at 633).

Taxation Determination TD 93/3 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income?, further discusses the Commissioners view on whether some lump sum payments are assessable as ordinary income.

Paragraph 4 of Tax Determination TD 93/3 states:

The weekly 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, etc (FC of T v. Inkster 89 ATC 5142; 20 ATR 1516). We consider that a lump sum payment, which is a partial commutation of weekly payments, does not change its character of compensation for loss of income. Effectively, the payment is an advance of future weekly payments. Consequently, it continues to be assessable……….

Sommer v. FC of T 2002 ATC 4815; 51 ATR 102 (Sommer's case).

This view has also been 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 as consideration for the cancellation of the policy, and the surrender of his rights under it or that the payment was capital as it was an undissected 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 revenue account. The fact that the payment was received in one lump sum did not change its revenue character.

Gorton v FC of T [2008] AATA 280 (Gorton's case)

The Sommer decision was followed by the AAT in Gorton v FC of T [2008] AATA 280 (Gorton) which involved a medical practitioner who had taken out a professional income replacement policy. Injuries he sustained in a motor vehicle accident prevented him from continuing in his medical practice. He received monthly payments under the policy until the insurer alleged that the taxpayer was in breach of the terms of the policy and denied further liability. Following negotiations the taxpayer received a lump sum payment in return for signing a deed of release for the benefit of the insurer which extinguished the policy and any right the taxpayer had for future claims under it.

In his judgment AAT member RG Kenny stated that he was satisfied that the observations made in Sommer were equally applicable to the lump sum payment made to the taxpayer. It was held that there was no capital component in the lump sum paid to the taxpayer, and the substance and commercial reality of the settlement was one comprising 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. The payment comprised ordinary income and was therefore assessable.

Your circumstances

In your case, the income protection policy that you held was meant to provide you with regular receipts if you became incapacitated and unable to derive assessable income. These receipts are ordinary income and are included in assessable income under section 6-5 of the ITAA 1997.

You became unable to derive assessable income due to a work place accident. When this occurred your income protection policy provided you with 'disability income benefits' to replace the loss of income pursuant to the policy. These receipts were ordinary income according to ordinary concepts and therefore assessable under subsection 6-5(2) of the ITAA 1997.

When your disability income benefits ceased, you commenced legal proceedings to have the payments reinstated. As a result of these proceedings you have been offered a lump sum payment in full settlement of the policy. If this occurs, any future regular payments will be commuted to a lump sum. As the disability income benefits were ordinary income, the lump sum payment also retains the character of being ordinary income.

It is acknowledged that you became entitled to the disability income benefit after incurring a work place injury, however the legal proceedings that you have undertaken directly relate to the reinstatement of disability income benefits only and not compensation for any injury or wrong doing. It is also acknowledged that in accepting the lump sum you will give up your rights in relation to the policy. However, consistent with the principles established in Sommer's case the lump sum represents redemption of the right to receive income and therefore is also regarded as income in nature.

Therefore, as the lump sum payment that you will receive is a replacement for assessable income it is income according to ordinary concepts. For this reason this payment will be assessable in the year that you receive it under subsection 6-5(2) of the ITAA 1997.

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