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Edited version of your written advice
Authorisation Number: 1051454975253
Date of advice: 27 November 2018
Ruling
Subject: Income protection lump sum payment
Question
Is the tax payable on the lump sum payment received in lieu of ongoing monthly income protection payments subject to income averaging?
Answer
No
This ruling applies for the following period:
Year ended 30 June 20XX
The scheme commences on:
1 July 20XX
Relevant facts and circumstances
You are an Australian resident for taxation purposes.
You took out a professional income protection policy which covered you until your 65th birthday.
You sustained a workplace injury.
Your insurance company determined you were eligible for weekly total disability benefits, which then changed to monthly payments.
In consideration of your worsening health conditions, your insurance company offered you a lump sum payment settlement to cover the monthly income protection for the remaining benefit period which would extinguish any and all future entitlements under the policy.
You agreed to and signed the Deed of Release.
You received the settlement.
The policy was then cancelled.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 6-5
Income Tax Assessment Act 1997 Subsection 6-5(2)
Income Tax Assessment Act 1997 Section 6-10
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.
An amount paid to compensate for loss generally acquires the same nature of what it is substituting (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).
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 received as a product of any employment, services rendered, or any business;
● are earned;
● are received regularly or periodically;
● are expected; and
● are relied upon.
It is not necessary for all of these characteristics to be present for an amount to be considered ordinary income. A lump sum payment is generally classified as ordinary income if it is simply a lump sum made up of periodic income payments but paid in arrears to cover a certain period.
Income protection policies provide for periodic payments in the event of loss of income caused by the insured becoming disabled through sickness or injury. These payments are assessable as income under section 6-5 of the ITAA 1997, as they are paid to take the place of lost earnings.
This view has been subsequently confirmed in Sommer v. FC of T 2002 ATC 4815; (2002) 51 ATR 102 (Sommer’s case) where a lump sum paid to a doctor in settlement of his claim under an income protection policy was assessable on the basis that it was in substitution for his original claim under the policy for lost income. The taxpayer argued that the amount comprised an undissected aggregation of both income and capital and, therefore should be treated as capital.
The taxpayer’s case was dismissed in the Federal Court and it was held that the commercial reality of the payment was that it was a full and final settlement of all the taxpayer’s income claims. The fact that it was a lump sum did not change its revenue nature.
The Sommer decision was followed in Gorton v. FC of T 2008 ATC 10-018, where a lump sum payment received by a former medical practitioner from his insurer in settlement of his professional income replacement claims was held to be assessable income.
Your situation is similar to the above cases as the lump sum you will receive will be a payout of your remaining benefit and finalisation of your claim.
The commutation of the monthly payments into a lump sum does not change its character of compensation for loss of income. The lump sum is a receipt of income only, that is, there is no capital component in the payment.
Therefore, the lump sum payment you received from the insurer is an advance of your future monthly payments and is assessable under section 6-5 of the ITAA 1997 as ordinary income in the year it is received.
As the lump sum payment you received is taxable in the year it is received, income averaging cannot be applied. Income averaging is only available in certain circumstances which cannot be applied to your circumstances.
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