Edited version of private advice

Authorisation Number: 1051629348886

Date of advice: 30 January 2020

Ruling

Subject: Settlement sum

Question 1

Is the settlement sum assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Does the receipt of the settlement sum give rise to a capital gain tax (CGT) event under the CGT provisions?

Answer

Yes, however any capital gain will be reduced to nil under section 118-20 of the ITAA 1997 as it is included as assessable income under another provision.

This ruling applies for the following period

Year ended 30 June 2020

The scheme commenced on

1 July 2019

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

On xxxx, you commenced an insurance policy with entity A.

The policy contained two components, a Life Protection Plan and a Professional Income Protection (PIP) plan.

The Life Protection plan was for a sum insured of $xxx and had an expiry date of xxxx.

The PIP plan was for a sum insured of $xxx per week provided for a benefit period to age 65 for injury or sickness. The PIP plan did not provide for a separate superannuation component and had an expiry date of xxxx.

In xxxx you were diagnosed with an illness.

On about xxxx you made a claim for an income protection benefit under the policy.

In late xxxx, you were diagnosed with a disorder.

Entity A was transferred to entity B on xxxx.

Entity B accepted the claim and you received a monthly income protection benefit in respect of the claim from xxxx.

As a result of the claim process with entity B, you suffered inconvenience, mental anguish and distress as a result of the non-payment of the income benefits and the late payment of the income benefits.

Entity B would frequently delay making scheduled payments, causing you economic hardship, as you relied on the payment for your financial security.

On one occasion in xxxx, entity B entirely neglected to make a scheduled payment, causing you mental anguish and distress.

Entity B would require you to regularly visit a doctor and would pressure you to return to the workforce in circumstances where it was not prudent for you to do so, when regard was had to your medical condition, causing you mental anguish and distress.

You approached entity B in xxxx regarding the possibility of a lump sum payment in settlement of your claim, the policy and any other potential causes of action you may have against entity B.

The discussions were habitually delayed as a result of multiple changes in the entity B case manager allocated to your claim.

On xxxx, entity B wrote to you with respect to a settlement sum of $xxx and advised that the PIP benefit under the policy will be cancelled. A draft Deed of Release was enclosed with the letter.

The letter stated:

·        As agreed, we confirm entity B has prepared a Deed of release in the sum of $xxx on a commercial basis and without any admission of ongoing liability for monthly income protection benefits for the above policy for the remaining benefit period.

·        Entity B will no longer pay any monthly benefits, or other benefit or consideration under your Policy.

·        Your policy will be cancelled and you will not be able to bring another claim or dispute under this Policy in the future.

The final Deed of Release (the Deed) was executed on xxxx and you received the settlement sum on this date.

Entity B did not provide you with any details with respect to how the settlement sum was calculated.

Entity B will no longer have an ongoing liability for monthly income protection benefits for the remaining benefit period. Entity B will no longer pay any monthly benefits, or other benefit or consideration under the policy.

Without admission of liability, you and entity B agree to compromise the claim and any past and future rights and obligations under the policy on the terms as outlined in the Deed.

Under the Deed you release and discharge entity B from all sums of money, accounts, claims, actions, proceedings, demands and expenses which you at any time had or may have against entity B, whether known or unknown to the parties (and if known by a party whether or not it was disclosed to the others) at the date of this Deed, in relation to the claim and the policy.

The Policy will be terminated by entity B on receipt of this Deed executed by you.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 section 15-30

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-20

Detailed reasoning

Generally, an amount received in relation to an insurance policy for income protection would be assessable either as:

·        ordinary income under section 6-5 of the ITAA 1997 (whether received as regular payments or a lump sum)

·        statutory income under section 15-30 of the ITAA 1997 (where a lump sum insurance payment is paid in lieu of regular, otherwise assessable payments and it is not itself ordinary income); and/or

·        a capital gain as capital gains tax (CGT) event C2 will also happen, but any resulting capital gain is disregarded to the extent that it is assessed under another provision (section 118-20 of the ITAA 1997).

Ordinary income and lump sum payment

Subsection 6-5(2) of the 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.

Based on case law, it can be said that ordinary income generally includes 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 according to ordinary concepts (FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

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 an income protection 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.

The issue of whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability was considered in Coward v. FC of T 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 redemption of those future weekly payments was also income.

This is consistent with the approach taken by the Commissioner in Taxation Determination TD 93/3 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income? As outlined in paragraph 4 of TD 93/3, such a commutation would result in the lump sum remaining assessable, as its effect was simply to pay in advance the future weekly payments.

This view was subsequently 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 in the consideration of 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.

In your case, the income protection policy was providing income. The regular payments received in relation to this policy replace lost earnings (salary). The purpose of the payments is a substitute for the income which would otherwise have been earned.

You were offered a lump sum payment in full settlement of the policy. That is, your future regular payments will be commuted to a lump sum. The lump sum will be paid to substitute for loss of income which otherwise would have been earned. As the periodic income replacement payments are ordinary income, the lump sum payment also retains the character of being ordinary income.

It is acknowledged that you also gave up all rights under the policy and you also cancelled the Life Protection Plan as well as the Professional Income Protection plan. However no amount of the settlement sum has been attributed to your rights and/or cancellation of the policy. Cancelling an insurance policy does not automatically result in a monetary payment. The letter dated XX XXXX 2019 refers to the sum of $X relating to the ongoing liability for monthly income protection benefits for the remaining of the benefit period. The only claim made was for an income protection benefit. It is acknowledged that you suffered mental anguish and distress, however there is no information to show that any amount of the settlement sum relates to this. The payment is not considered to be an undissected lump sum. There is no information in the Deed of Release to say that any of the settlement sum relates to the cancelling of the policy or giving up your rights.

Consequently, the lump sum payment is assessable as ordinary income under section 6-5 of the ITAA 1997.

Statutory income

Where an insurance amount is not regarded as ordinary income under section 6-5 of the ITAA 1997, it is generally assessable under section 15-30 of the ITAA 1997. Section 15-30 operates to include in assessable income any amount received by way of insurance or indemnity for the loss of an amount if the lost amount would have been included as assessable income but was not assessable under section 6-5.

As you payment is assessable under section 6-5 of the ITAA 1997, section 15-30 of the ITAA 1997 does not apply in your circumstances.

Capital gains

While a payment may be characterised as ordinary income, a capital gain may still be made. However, an anti-overlap provision prevents income being assessed as both ordinary or statutory income and a capital gain, the latter being reduced to the extent it is assessed by the former (see section 118-20 of the ITAA 1997).

Part 3-1 of the ITAA 1997 contains the general capital gains and capital loss provisions commonly referred to as the CGT provisions. You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts advocates a look-through approach, which identifies the most relevant asset to which the compensation amount is most directly related. Paragraph 11 of TR 95/35 states that if an amount is not received in respect of an underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

As the amount you will receive is a final settlement and is not in respect of an underlying asset, the whole of the settlement amount is treated as capital proceeds from your right to seek compensation.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation.

The net capital gain made is then included in your assessable income under section 102-5 of the ITAA 1997 (after being reduced by the aforementioned overlap provisions as required).

In your case, as any CGT would be reduced to nil under section 118-20 of the ITAA 1997, any CGT exemption is not relevant.

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).