Edited version of private advice

Authorisation Number: 1051618183302

Date of advice: 26 March 2020

Ruling

Subject: Assessability of a lump sum

Question 1

Is the lump sum payment (LSP) you received to give up your right to take legal action assessable as ordinary income?

Answer

No.

Question 2

Can you disregard any capital gains arising from the LSP of $X paid to you by the Insurer?

Answer

No.

Question 3

Are you entitled to use the discount method to calculate the capital gains?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You received a LSP of $X under a Deed of Release (the Deed) with the Insurer.

You were insured with your former employer's corporate insurance policy (the Policy) through your former employer. You did not pay any sum to your former employer or the Insurer to be insured under the policy.

You suffered injury in the workplace

The Insurer paid you regular benefits for several years on the basis you were suffering a total disability under the Policy.

The Insurer declined to make further payments to you alleging that you no longer suffered a total disability.

You disputed the Insurer's decision through your lawyers (the Lawyers).

The Insurer at all times denied your claim from the date they ceased paying. Despite the Insurer's extensive review of additional material following this date, including an independent medical opinion sought by you showing that you suffered psychological disorders and you could not return to your previous line of employment, the Insurer continued to deny they had an obligation to pay income benefits to you. The Insurer reaffirmed this to you in a letter stating that the claim was closed and you had no entitlement to benefits under the Policy.

You state the only reason the Insurer agreed to pay you the LSP was to avoid adverse publicity. This is evidenced by the terms of the Deed of Release, particularly Confidentiality requirements that cover the facts of your case and the terms of settlement.

You state that the payment made to you was not, therefore, a substitution for future income that would have been assessable income under the policy. Rather, it was a payment of a capital nature for severe distress suffered by you which is not an income payment. The Insurer effectively acknowledged the severity of the distress by the quantum of the payment.

Your medical advisor confirmed the earlier opinion that you had a severe condition and that there was very little likelihood of the condition remitting while the case continued.

Evidence that the Insurer at all times refused the claim and only entered mediation reluctantly and under legal pressure includes:

• The Insurer only agreed to participate in mediation of your claim after the Lawyers wrote a confidential letter to the Insurer. The Insurer then responded with a letter, a copy of which has been supplied.
• The Insurer's denial of the claim in its letter, a copy of which has been supplied.
• The Insurer did not change its position on receipt of your medical advisor's report.
• The Insurer continued to deny the claim in its Position Paper, a copy of which has been supplied.
• The Insurer demonstrated that they did not view the LSP to you as a benefit payment given they did not withhold tax from the payment.

Relevant legislative provisions:

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

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 115-100

Reasons for decision

Assessable income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, 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 examples of ordinary income.

Receipts that are not salary or wages but are paid as a substitute for salary or wages that would normally have been earned, expected and relied upon by a taxpayer are also assessable as ordinary income.

The general principle is that such payments take on the character of the salary or wages they replace. That is, if the substituted amount was an amount of ordinary income, the amount paid to compensate for the loss of that amount will also be ordinary income.

In your case, the LSP of $X was paid to you because you signed the Deed of Release in which you agreed to give up your right to legal action regarding the loss of the regular monthly payments from the Insurer under the Policy.

As the LSP is not compensating you for loss of income that would have been assessable income (the regular monthly payments), the LSP is not assessable as income.

Statutory income and capital gains tax (CGT)

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

The general CGT provisions are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions a taxpayer will make a capital gain or loss only if a CGT event happens to a CGT asset.

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates.

The Commissioner's policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts

Taxation Ruling TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be:

• an underlying asset, or
• a right to seek compensation.

In determining which is the most relevant asset, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt.

In TR 95/35 the term 'underlying asset' is used. The underlying asset is defined in TR 95/35 as:

the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

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 3-1. 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. This disposal triggers a CGT C2.

In your situation, the LSP was be made to compensate you for surrendering your right to take legal action to seek compensation for the loss of the regular payments from the Insurer. It is viewed as being consideration received for the disposal of your right to seek compensation. You disposed of your right to seek compensation when you entered into a Deed of Release. This triggered CGT event C2 under section 104-25 of the ITAA 1997.

Accordingly, the LSP that you received from the Insurer is assessable under section 6-10 of the ITAA 1997.

CGT discount method

Under section 115-100 of the ITAA 1997, an individual is entitled to discount the capital gain made as a result of a CGT event by 50 percent provided:

• You're an individual
• The CGT event happens after 21 September 1999 and
• The CGT asset was acquired at least 12 months before the CGT event happening.

In your situation, the Insurer ceased paying you the regular payments and you signed the Deed of Release. As your right to take action arose more than 12 months before you received the LSP, a 50 percent discount will apply to reduce your capital gain.

To calculate your net capital gain using this method you subtract the cost base from the capital proceeds, deduct any other capital losses, if you have a positive result reduce this by 50%.

You can find additional information about the discount method of calculating your CGT at www.ato.gov.au and enter quick code QC 17159 into search.

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