Edited version of your written advice

Authorisation Number: 1051305586266

Date of advice: 9 November 2017

Ruling

Subject: CGT

Question 1

Will any part of your settlement constitute assessable income in the 2017-18 income year?

Answer:

Yes.

Question 2

Will any part of your settlement be exempt in accordance with paragraph 118-37(1)(b) of the ITAA 1997?

Answer:

No

Question 3

Can you add the payment made to the trustee in bankruptcy to the cost base of your Capital Gains Tax (CGT) asset pursuant to sections 110-25 or 110-35 of the ITAA 1997?

Answer:

No

Question 4

Can you add the costs of the legal fees you incurred in relation to your action against the Entity to the cost base of your CGT asset pursuant to sections 110-25 or 110-35 of the ITAA 1997?

Answer:

Yes

Question 5

Are you eligible to apply the 50% general discount available to individual taxpayers on the capital gain arising as a result of CGT event C2 as per section 115-100(a)(i) of the ITAA 1997?

Answer:

Yes

This ruling applies for the following periods:

Year ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

1. You commenced an income protection policy with the Entity (Policy).

2. You subsequently suffered an illness.

3. The Entity commenced paying insurance pursuant to the Policy.

4. You were made bankrupt.

5. The Entity ceased paying the benefit.

6. You sought a review of the Entity’s decision to stop payment.

7. Your solicitors commenced a Claim in court to enforce your rights against the Entity.

8. You made a proposal for composition of your bankruptcy.

9. You transferred money from your Account to the Trustee of your bankrupt Estate (the Trustee).

10. You withdrew your proposal for a composition.

11. You entered into a Deed of Settlement (Deed of Settlement) with the Trustee.

12. It was a term of the settlement that the Trustee assigned all and any rights vested in the Trustee, in respect of the Policy and the Claim, in you.

13. The Deed also released you from your liability to pay the outstanding income contributions.

14. Prior to your legal action against the Entity being heard by the Court, the Entity made an offer to you of a one-off un-dissected payment. The offer is made without admission of liability and payment will be made after you enter into a Deed of Release (Deed of Release).

15. The operative provisions of the Deed provide that the Policy will be terminated and you will discontinue your court proceedings within two days of payment.

16. You intend to accept this offer.

17. You have provided a copy of the Policy, the Writ, the Deed of Settlement and the Deed of Release.

18. You have also provided a copy of a transaction history from your Account.

19. Your agent has advised that you are unaware how the settlement figure was calculated.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-30

Income Tax Assessment Act 1997 Section 100-30

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 106-30

Income Tax Assessment Act 1997 Subsection 106-30(2)

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 115-5

Income Tax Assessment Act 1997 Paragraph 118-37(1)(a).

Income Tax Assessment Act 1997 Paragraph 118-37(1)(b).

Bankruptcy Act 1966 Section 5A

Bankruptcy Act 1966 Section 58

Bankruptcy Act 1966 Section 116

Life Insurance Act 1995 (Cth) Section 9

Life Insurance Act 1995 (Cth) Section 9A

Life Insurance Act 1995 (Cth) Section 204

Reasons for decision

Question 1 and Question 2

Summary

The money you will receive on settlement is assessable income under the CGT provisions and is not exempt from tax.

Detailed reasoning

Assessable income consists of income according to ordinary concepts (ordinary income) and other amounts which are included in assessable income under provisions of the Income Tax Assessment Act 1997 (ITAA 1997) or the Income Tax Assessment Act 1936 (ITAA 1936) (statutory income). Statutory income includes net capital gains. Assessable income does not include exempt income or non-assessable non-exempt income.

Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts (ordinary income). If you are an Australian resident, your assessable income includes the ordinary income you derived from all sources, including those outside of Australia.

The courts have identified a number of factors which indicate whether an amount has the character of income according to ordinary concepts. A frequent, though not required, characteristic of income receipts is an element of periodicity, recurrence or regularity, even if the receipts are not directly attributable to employment or services that have been rendered. However, a lump sum payment can still constitute ordinary income. In particular, the conversion of a periodic payment to a lump sum does not alter the nature of the payment from an income receipt to a capital one.

In McLaurin v FCT (1961) 104 CLR 381 (McLaurin), Dixon CJ and Fullagher and Kitto JJ, considered the taxation consequences of an un-dissected lump sum compensation payment. In that case McLaurin made a claim for damages against the Commissioner of Railways for damage caused on his grazing property by a fire. Damages were claimed under a number of heads. The Commissioner of Railways offered a lump sum payment in full settlement of all claims for damage arising out of the fire. In finding that the lump sum compromised amounts which had not been dissected into their constituent parts and was capital in nature, the Court stated at 391:

It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst the several heads to which it relates and an income or non-income nature attributed to portions of it accordingly… But while it may be appropriate to follow such a course where the payment or receipt is in settlement of distinct claims of which some at least are liquidated or are otherwise ascertainable by calculation…it cannot be appropriate where the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages. In such a case the amount must be considered as a whole.

The Commissioner’s view on the common law principle in McLaurin is clarified in Taxation Determination: TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? (TD 93/58). TD 93/58 explains the ATO view on the assessability of lump sum compensation/settlement under the predecessor to section 6-5 of the ITAA 1997, subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936). TD 93/58 referring to a lump sum payment, provides:

1. It is assessable income under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA):

(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 …

…

3. In the circumstances of paragraph 1 (a) there is a receipt of income only, that is, there is no capital component in the payment. It is therefore not relevant that the basis of the calculation of the lump sum cannot be determined.

4. In the circumstances of paragraph 1 (b) there is included in the lump sum a receipt of a capital nature, but the `ingredients' of the payment can be identified, and therefore the portion of the payment which relates to income is assessable.

The character of the receipt in the hands of the recipient must also be considered.

In Taxation Ruling TR 95/35: Income Tax: Capital Gains Tax: Treatment of compensation receipts, the Commissioner, referring to the decision of Bowen CJ, Lockhart and Sheppard JJ in FCT v Slaven 84 ATC 4077 at 4985, stated that whether a lump sum or other compensation payment is assessable in the hands of the recipient depends on whether it is a receipt of a capital or income nature. This in turn depends upon consideration of all the circumstances surrounding the payment. It is the character of the receipt in the hands of the recipient that must be determined.

Statutory income

If a settlement or compensation payment is not assessable as ordinary income, it may still be assessable as statutory income under section 15-30 of the ITAA 1997, if the lost income the compensation payment represents would have been assessable under section 6-5 of the ITAA 1997. Section 15-30 of the ITAA 1997 operates to include in a taxpayer's assessable income;

'An amount you receive by way of insurance or indemnity for the loss of an amount (the lost amount) if:

(a) the lost amount would have been included in your assessable income; and

(b) the amount you receive is not assessable as ordinary income under section 6-5.'

Payments of capital may also be assessable as statutory income under the CGT provisions. Section 102-5 of the ITAA 1997 provides that your assessable income includes your net capital gain for the income year.

Section 104-25 of the ITAA 1997 contains the rules dealing with CGT event C2. CGT event C2 happens if a taxpayer's ownership of an intangible CGT asset ends because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.

TR 95/35 defines the right to seek compensation as:

The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part IIIA. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

Your right to seek compensation to enforce your Policy is an intangible capital asset.

Section 100-30 of the ITAA 1997 provides that a capital gain can be disregarded if there is an exception or exemption that allows it to be disregarded. Paragraphs 118-37(1)(a) and (b) of the ITAA 1997 contains CGT exemptions for compensation or damages an individual receives for wrong, injury or illness as follows:

'A capital gain or capital loss you make from a CGT event relating directly to any of these is disregarded:

(a) compensation or damages you receive for any wrong or injury you suffer in your occupation; or

(b) compensation or damages you receive for any wrong, injury or illness you or your relative suffers personally.

Subsection 118-37(1) of the ITAA 1997 replaced section 160ZB of the ITAA 1936. The meaning of whether an amount is compensation or damages for the purposes of 160ZB of the ITAA 1936 is to be interpreted broadly.

However, in TR 95/35 the Commissioner adopts a look through or underlying asset approach to determine the asset that has been disposed of. If the amount of compensation received is an un-dissected lump sum, the whole amount is treated as being consideration received for the disposal of the right to seek compensation. However, if all of the separate heads of claim relate to the personal injury of the taxpayer, and there are no other non-personal injury elements of compensation within the total claim, the exemption continues to apply to the compensation.

TD 14 Capital Gains: Will payments made under Accident & Health Assurance policies be exempt from CGT? provides that personal injury insurance can qualify for the exemption under former subsection 160ZB(1) of the ITAA 1936.

Application to your circumstances

The issue to be determined is the character that the proposed lump sum payment from the Entity will take in your hands.

The operative provisions of the Deed make it clear that the proposed compensation payment will be made on the basis that you will discontinue legal action against the Entity.

As the Deed treats the lump sum as a single un-dissected amount for the surrendering of rights it is capital in nature.

As the compensation payment is considered capital, section 6-5 of the ITAA 1997 will not apply as the payment is not ordinary income.

Similarly, section 15-30 of the ITAA 1997 will not apply to your compensation amount as it was not paid for loss of earnings but in satisfaction of you surrendering your capital rights.

The proposed lump sum payment will be paid to you for entering into a contract to discontinue the Claim. The Policy will terminate. As your rights in an intangible asset, the right to seek compensation, will end, CGT event C2 will occur.

Whilst your rights to seek compensation arose from your injury, the look-through approach shows that the payment you will receive is not a payment for a personal injury or illness, but a payment for giving up the Claim. Because the payment will be made in return for you giving up the Claim, it is not compensation or damages for a wrong, injury or illness you suffered personally. The Entity explicitly does not accept liability under the Policy. Although the settlement figure may have been triggered by a personal illness, the actual lump sum payment is for disposal of your right to seek compensation. Therefore the exemption contained in section 118-37(1)(b) of the ITAA 1997 cannot apply and the payment will be a taxable capital gain.

Question 3 and Question 4

Summary

The payment you made to the Trustee cannot be added to the cost base of your CGT asset.

Detailed reasoning

You will make a capital gain on the disposal of your right to sue if the capital proceeds from event C2 are more than the asset’s cost base. It is therefore necessary to establish the cost base of your right to seek compensation. Section 110-25 of the ITAA 1997 contains general rules about the cost base of an asset. Essentially, the cost base of a CGT asset consists of 5 elements, which are set out in subsections 110-25(2) to 110-25(6) of the ITAA 1997.

The five elements of cost base are:

First element: 110-25(2) of the ITAA 1997.

The first element is the total of:

(a) the money you paid, or required to pay, in respect of acquiring it; and

(b) the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

Second element: 110-25(3) of the ITAA 1997.

The second element are the incidental costs you incurred to acquire the property. These costs can include giving property. Incidental costs that can be included in the cost base of a CGT asset are set out in section 110-35 of the ITAA 1997. Incidental costs are:

● remuneration for services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser. Remuneration for professional advice about the operation of the Act is not included unless it is provided by a recognised tax adviser;

● stamp duty or other similar duty;

● costs of advertising or marketing to find a seller or costs of advertising or marketing to find a buyer;

● costs of transfer;

● costs relating to the making of any valuation or apportionment for the purposes of Part 3-1 or Part 3-3;

● search fees relating to a CGT asset;

● borrowing expenses (such as loan application fees and mortgage discharge fees);

● expenditure that is incurred by the head company and related to a CGT asset held by the head company and is incurred because of a transaction that is between members of the group;

● termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending.

In particular, section 110-35(3) of the ITAA 1997 relates to the costs of transfer.

Third element: subsection 110-25(4) of the ITAA 1997.

The third element is the costs of owning the CGT assets you have incurred. These costs include:

(a) interest on money you borrowed to acquire the asset; and

(b) costs of maintaining, repairing or insuring it; and

(c) rates or land tax, if the asset is land; and

(d) interest on money you borrowed to refinance the money you borrowed to acquire the asset; and

(e) interest on the money you borrowed to finance the capital expenditure you incurred to increase the asset’s value.

These costs can include giving property: see section 103-5.

Fourth element: 110-25(5)

The fourth element is capital expenditure you incurred:

(a) the purpose or the expected effect of which is to increase or preserve the asset’s value; or

(b) that relates to installing or moving the asset.

Fifth element: 110-25(6)

The fifth element is capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over the asset.

Application to your circumstances

In your case, you state you have incurred legal fees in relation to the legal action and should be able to add these to the cost base. You contend that these figures should be added to your cost base pursuant to subsections 110-25(3) and 110-35(3) of the ITAA 1997 (relating to incidental costs). The Commissioner accepts that your legal fees related to bringing and settling the legal action can be added to your cost base. You would however need to be able to substantiate these amounts.

The Commissioner’s view is that the other payment cannot be added to your cost base as the Trustee did not have any rights under the Policy.

Section 58 of the Bankruptcy Act deals sets out what property of the bankrupt vests in the Trustee upon bankruptcy. Section 58 also sets out which after-acquired property of the bankrupt vests in the Trustee when it is acquired by, or devolved on, the bankrupt. The definition of ‘property of the bankrupt’ in section 5A of the Bankruptcy Act makes it clear that the only property that can vest in the Trustee is property that is divisible under section 116 of the Bankruptcy Act.

Section 116(1) of the Bankruptcy Act provides an exhaustive list of property that is divisible amongst the creditors of the bankrupt (and therefore able to vest in the Trustee). Section 116(1) of the Bankruptcy Act provides that divisible property includes:

(a) all property that belonged to, or was vested in, a bankrupt at the commencement of the bankruptcy, or has been acquired or is acquired by him or her, or has devolved or devolves on him or her, after the commencement of the bankruptcy and before his or her discharge; and

(b) the capacity to exercise, and to take proceedings for exercising all such powers in, over or in respect of property as might have been exercised by the bankrupt for his or her own benefit at the commencement of the bankruptcy or at any time after the commencement of the bankruptcy and before his or her discharge.

It is accepted that prima facie this would include the Policy and the Claim. However, section 116(2)(d) of the Bankruptcy Act provides that section 116(1) of the Bankruptcy Act does not extend to

(i) policies of life assurance or endowment assurance in respect of the life of the bankrupt or the spouse or de facto partner of the bankrupt;

(ii) the proceeds of such policies received on or after the date of the bankruptcy.

Therefore, if the Policy is a policy of life assurance, the Policy and the Claim cannot vest in the Trustee as they are excluded from being divisible property.

The meaning of a policy of life assurance or endowment assurance is not defined in the Bankruptcy Act. However, section 9(1)(e) the Life Insurance Act 1995 (Cth) (LIA) does define the meaning of a ‘life policy.’ It is considered that the LIA definition of ‘life policy’ is an appropriate guide to the meaning of a ‘policy of life assurance’ in the Bankruptcy Act.

Section 9(1)(e) of the LIA provides that:

(1) Subject to subsection (2), each of the following constitutes a life policy for the purposes of this Act:

….

(e) a continuous disability policy;

Section 9A of the LIA then defines a “continuous disability policy” as follows:

(1) Subject to this section, a continuous disability policy is a contract of insurance:

(a) that is, by its terms, to be of more than 3 years' duration; and

(b) under which a benefit is payable in the event of:

(i) the death, by accident or by some other cause stated in the contract, of the person whose life is insured (the insured ); or

(ii) injury to, or disability of, the insured as a result of accident or sickness; or

(iii) the insured being found to have a stated condition or disease.

Pursuant to the terms of the Policy, as it was a policy of more than 3 years duration, section 9A(1)(a) of the LIA is satisfied. Section 9A(1)(b) of the LIA is also satisfied as it was a term of the Policy that if you were totally disabled and could not work you were entitled to a weekly benefit for life. None of the disqualifying criteria in subsections 9A(2)-(7) of the LIA applies.

The Policy comes under the protection of section 204 of the LIA which provides that the rights and interests of a person under a life policy effected on his or her life are not liable to be applied or made available by any judgment, order or process of a court in discharge of a debt owed by the person. This protection applies regardless of when a policy was issued and whether or not the policy is owned by the person.

Notably subsection 204(3) makes the protection subject to the Bankruptcy Act. Subsection 116(2)(d) of the Bankruptcy Act also excludes policies of life from being divisible amongst creditors.

The Commissioner is satisfied that the Policy is a life policy for the purposes of the LIA and this provides guidance that the Policy is a policy of life assurance for the purposes of the Bankruptcy Act.

As the Policy is a policy of life assurance, it is not property that is divisible amongst creditors. As the Policy and rights pertaining to the enforcement of the Policy were not and are not divisible against creditors they were not ‘property of the bankrupt’ capable of vesting in the Trustee.

The consequence is that the Trustee did not, as he could not, sell or transfer to the bankrupt the rights to the Policy or the right to continue with the Claim against the insurer. Thus, the money paid by the bankrupt to the Trustee could not be to acquire the rights to sue the insurer and thus cannot be an amount to be included in the cost base for that gain pursuant to section 110-25(6), nor subsections 110-25(3) or 110-35(3) of the ITAA 1997. It is considered to be an amount completely unrelated to the gain. The payment only related to the compromise that the Trustee was willing to accept in relation to his assessment of the income contributions that you were required to pay. It is also worth noting that the settlement figure is less than the outstanding income contributions.

In your case, your cost base is limited to the legal fees you incurred in bringing and settling the Claim pursuant to sections 110-25(3) and 110-35(3) of the ITAA 1997.

Question 5

Under section 115-5 of the ITAA 1997, you make a discount capital gain if the following requirements are satisfied:

● you are an individual, a trust or a complying superannuation entity

● a CGT event happens to an asset you own

● the CGT event happened after 11.45am (by legal time in the ACT) on 21 September 1999

● you acquired the asset at least 12 months before the CGT event, and

● you did not choose to use the indexation method.

Section 104-25 of the ITAA 1997 prescribes that the timing of CGT event C2 is:

(a) when you enter into the contract which results in the asset ending; or

(b) if there is no contract when the asset ends

In your case, the timing of CGT event C2 will be at least 12 months from when you acquired the asset.

Under the discount method you reduce your capital gain by the discount percentage. For individuals, the discount percentage is 50%. However, you can reduce the capital gain only after you have applied all the capital losses for the year and any unapplied net capital losses from earlier years.

The discount capital gain is included in your assessable income and taxed at the marginal rate applicable to you in that financial year.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).