Edited version of your written advice

Authorisation Number: 1013121613064

Date of advice: 11 November 2016

Ruling

Subject: Lump sum income protection insurance payment

Question

Should the lump sum payment from your income protection insurance policy be included in your assessable income for the 201X income year?

Answer:

Yes

This ruling applies for the following period

Year ending 30 June 201X

The scheme commenced on

1 July 201X

Relevant facts

You entered into a life and income protection insurance contract.

You will receive a lump sum payment under an income protection insurance policy.

Relevant legislative provisions

Income tax Assessment Act 1997 section 6-5

Reasons for decision

Assessability of lump sum payment  

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.

The lump sum payment you receive will be assessable under section 6-5 of the ITAA 1997 if it is found to be ordinary income. This will depend on whether the amount is payable in respect of the loss of earnings or in respect of the loss of earning capacity.

Payments to replace income are also considered to be income (Keily v. Federal Commissioner of Taxation (1983) 14 ATR 156: 83 ATC 4248). 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). 

Compensation payments which substitute income have also been held by the courts to be income according to ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; 89 ATC 5142, (1989) 20 ATR 1516) and Tinkler v. Federal Commissioner of Taxation 79 ATC 4641; (1979) 10 ATR 411).

In addition to this, 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). Thus, amounts payable under a policy that provides a monthly indemnity against income loss arising from inability to earn are of a revenue character (Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578 at 583-84; 11 ATR 538 at 540-41; 81 ATC 4114 at 4116).

Therefore, periodic payments received during a period of total or partial disability under a personal accident or disability insurance policy are assessable on the same principle as workers' compensation payments. Weekly or periodic workers' compensation payments (or periodic payments under other legislation) for loss of salary, either whole or in part, are assessable as ordinary income.

The character of a lump sum compensation payment or insurance benefit is derived from the terms of the particular policy or legislation and the reason for making the payment.

In your case, the lump sum payment is a result of an income protection policy taken out by you. The character of the lump sum paid to you is to replace income for the loss of earnings as a result of suffering a disability under the terms of the policy and is therefore considered to be ordinary income.

Commutation of a lump sum payment

The Commissioner's view outlined in Taxation Determination TD 93/3, and confirmed in Taxation Determination TD 93/58, views periodic payments paid as compensation for loss of income or salary as assessable income and that a lump sum payment, which is a commutation of such payments, retains its character as income. 

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.

In view of the above, it is considered that the lump sum payment you will receive is a commutation of the disability income benefits and therefore retains the character of the insurer's income protection policy from which it was derived. That is, the payment is ordinary income under section 6-5 of the ITAA 1997 as the lump sum payment amount is payable in respect of the loss of earnings and not in respect of the loss of earning capacity.

This view has been confirmed in Sommer v. Federal Commissioner of Taxation 2002 ATC 4815; 51 ATR 102 (Sommer's Case). This was an appeal heard in the Federal Court from a decision of the Administrative Appeals Tribunal. The case involved a medical practitioner who had taken out a Professional Income replacement insurance policy. Following rejection of the taxpayer's 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. Alternately, he argued that the amount comprised an undissected aggregation of both income and capital and therefore should be treated as capital.

In dismissing the taxpayer's 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.

In your case, the intention in taking out the income protection policy was to protect and provide income in the event of illness or disability. The lump sum that you will be paid is considered assessable income as it is compensation for loss of income that you would have been entitled to receive under the policy with the insurer. The relevant facts that apply to your case are similar to that found in Sommer's Case. It is therefore concluded that your lump sum payment is of an income nature and assessable under section 6-5 of the ITAA 1997.

Derivation of income

As noted under section 6-5 of the ITAA 1997, ordinary income is assessable in the income year in which it is derived.

Taxation Ruling TR 98/1 deals with the derivation of ordinary income and states that the general rule with non-trading income is that it is derived when it is received. 

Subsection 6-5(4) of the ITAA 1997 provides that in working out whether a taxpayer has derived an amount of ordinary income and when it was derived, the taxpayer is taken to have received the amount when it is applied or dealt with in any way on the taxpayer's behalf or as the taxpayer directs.

In your case, the payment is for loss of earnings and subsequently included as part of your assessable income for the 201X income year when it is received. We acknowledge the circumstances and associated tax liabilities. However, the Commissioner has no discretion to treat it otherwise.

In addition, your payment is not regarded as exempt under the ITAA 1997.

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