Edited version of your written advice

Authorisation Number: 4130057656606

Date of advice: 25 February 2019

Ruling

Subject: Compensation payment – Undissected Lump Sum

Question

Is the lump sum settlement amount received assessable as ordinary income?

Answer

Yes.

Question

Did the settlement cause a capital gains tax event to occur?

Answer

Yes, however, any capital gain you made at that time will be reduced to the extent that an amount is assessed as ordinary income.

Question

Is the Partnership entitled to the 50% CGT discount and approach of the net capital gain calculation is correct?

Answer

Invalid question.

This ruling applies for the following period:

Year Ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

You are in a partnership that carried on a farming business.

The partnership entered into an agreement with a company to supply infrastructure to the farm.

The partnership alleges that the infrastructure was defective and you suffered various losses as a result.

The partners of the partnership, in their individual capacity, issued proceedings against the company seeking relief. The initial claim was documented in a Summary of claim and consisted of costs involved with replacement of the system and loss of production.

On the XX April 20XX an out-of-court settlement was reached and a Deed of Settlement between the partnership and XXX was signed.

The Deed of Settlement states that

● The company and the partnership agree to resolve all issues in dispute between them, without any admission of liability.

● The company will pay the partnership a sum of $x,xxx,xxx.

● On payment of the sum, the company and the partnership forever discharges one another from any claims, actions, liabilities, suits, demands or proceeding whatsoever arising out of, or in any way related to, the subject matter of the Proceeding.

The Deed of Settlement does not provide a breakdown of the settlement amount.

The Sum in the deed of settlement was less than the original summary of claim.

The following documents have been considered as part of this ruling

● The Amended Statement of Claim dated XX November 20XX

● Deed of Settlement dated XX April 20XX

Relevant legislative provisions

Income Tax Assessment Act section 102-5

Income Tax Assessment Act section 6-1

Income Tax Assessment Act paragraph 108-5(1)

Reasons for decision

Compensation Receipts

The Commissioner's policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 Capital gains: treatment of compensation receipts (TR 95/35).

A compensation receipt, or compensation, includes any amount received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not it is:

● in relation to any underlying asset;

● arising out of Court proceedings; or

● made up of dissected amounts.

Ordinary Income

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 been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

The lump sum payment you received is not income from rendering personal services, income from property or income from carrying on a business. It is a one-off payment and thus does not have an element of recurrence or regularity.

However, 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). 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 (1979) ATC 4641; (1979) 10 ATR 411).

Generally payments for loss of profits due to interruptions to business operations or in connection with compensation or damages for the loss of anticipated profits are likely to be of an income nature. (Commissioner of Taxation (NSW) v Meeks (1915) 19 CLR 568)(Meeks).

In Meeks, the taxpayer conducted mining operations and entered into an agreement with a company. Under the agreement, the taxpayer was to sell to the company a large quantity of materials, delivery of which was to be made over a period of years. The company paid the taxpayer £63,000 but, before any deliveries were made, defaulted on the agreement. The agreement was cancelled and the taxpayer was entitled to retain a substantial portion of the £63,000. It was held by the High Court that the amount retained was assessable as profits from the taxpayer ' s business.

Griffith CJ stated (at p 580):

" In my opinion, damages received as compensation for non-performance of a business contract stand on the same footing as the profits for the loss of which the damages are paid. It cannot, therefore, make any difference in principle whether the money is actually earned as profit, ascertained by deducting expenses from receipts, or paid as compensation for the loss of the opportunity of earning that profit, or, in the latter case, whether the amount of compensation is assessed by jury or by mutual agreement. "

Other examples include:

A poultry farmer received compensation from the Wheat Board because of the presence of excessive amounts of pesticide in the wheat dust supplied by it which was used in poultry feed. This resulted in the death of many of the birds and substantially reduced egg production and the economy of the farm. In finding that the damages were assessable, the Federal Court said that the amounts awarded to compensate for loss of income are liable to tax as being in the general nature of " income ". (Gill v the Australian Wheat Board & Ors (1981) ATC 4217).

In Liftronic Pty Ltd v FC of T (1996) ATC 4425, the taxpayer sold, installed and maintained lift systems. One of its suppliers, supplied it defective equipment, and Liftronic received damages for breach of contract, including an amount for loss of profits. Foster J said that the breaches of the supplier did not destroy the goodwill or earning capacity of the taxpayer but merely temporarily impaired the income earning assets, resulting in a restriction of trading opportunities. This restriction created a " hole in profits " which the award of damages was intended to fill..

The use to which the taxpayer puts the compensation receipt has been found not to be a relevant factor (Carapark Holdings Ltd v FCT (1967) 115 CLR 653;).

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.

Capital Gains

Taxation ruling TR 95/35 also sets out the Commissioner’s views on the capital gains tax (CGT) implications of compensation payments under the corresponding provision of the Income Tax Assessment 1936 (ITAA 1936).

Notwithstanding the provisions referred to in TR 95/35, the ruling continues to be binding on the Commissioner, to the extent that the ITAA 1997 provisions express the same idea as those referred to in the ITAA 1936.

If the compensation receipt is directly in respect of an underlying CGT asset, that is for the disposal of, loss of, permanent damage to, or permanent reduction in the value of, that asset. The approach in the Ruling allows the taxpayer to look through the right to seek compensation and treat the amount as having been received in relation to the underlying asset. For example, if compensation is received because a tangible asset is lost or destroyed, then the compensation receipt will be treated as capital proceeds for CGT event C1 happening to the asset.

If there is no underlying asset to which the compensation receipt directly relates, the receipt will be capital proceeds for CGT event C2, the ending of the right to seek compensation.

CGT event C2

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes a net capital gain. A CGT asset is defined in paragraph 108-5(1)(b) of the ITAA 1997 as including a legal or equitable right that is not property.

The CGT provisions treat the right to sue for damages (or the right to give up the right to sue) as an asset, which can be disposed of by obtaining an award of damages, or by accepting a settlement amount.

CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset being satisfied or surrendered. A C2 event can apply where there is a release or discharge of a right to sue on the settlement of a legal dispute (See Re Coshott and FCT (2014) AATA 622).

The disposal of the right to seek compensation is discussed in further detail in the following pages.

Undissected amounts

An undissected lump sum compensation receipt is any amount of compensation received where the components of the receipt have not been and cannot be determined or otherwise valued or reasonably estimated.

It is likely that a lump sum compensation amount can be dissected using information available such as the deed of settlement or the original summary of claim.

Paragraph 3 of TR 95/35 defines an undissected lump sum compensation receipt as:

Any amount of compensation received by the taxpayer where the components of the receipt have not been and cannot be determined or otherwise valued or reasonably estimated.

As explained at paragraph 188 of TR 95/35, whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt, and the reasons why it was paid to the taxpayer.

Further to the above paragraph 190 of TR 95/35 states, it has been argued that ‘the mere fact that compensation has been awarded as a lump sum, and has not been dissected into its component elements’, is a sufficient reason to treat the whole receipt as one of capital.

However, the ATO does not accept the above argument per se. In the Commissioner’s view, the facts and circumstances surrounding the receipt may still enable an apportionment of the lump sum payment on a ‘reasonable basis’ into its constituent elements.

The effect of TR 95/35, as applied to the ITAA 1997, is that if compensation relates to a number of heads of claim, section 116-40 of the ITAA 1997 requires the taxpayer to apportion the compensation on a ‘reasonable basis’ to each of those claims.

However, TR 95/35 also states that, if the taxpayer cannot, or does not, make a reasonable estimate, valuation, or calculation of the amounts that are reasonably attributable to each claim, the ATO will make the allocation using the information that is available in relation to those claims.

Can the lump sum payment be apportioned on a reasonable basis?

The case of McLaurin v. FC of T (1961) 104 CLR 381 (the “McLaurin case”) is discussed at paragraphs 190 to 194 of TR 95/35. In that case the taxpayer accepted the defendant’s offer of a lesser amount as a lump sum in full settlement of his claim. However, the taxpayer accepted the sum without knowing the basis of the final calculation. The Commissioner sought to assess the taxpayer on that portion of the lump sum that was of an income nature, based on the defendant’s list of particulars.

The High Court in the McLaurin case held that the lump sum was not assessable income because the settlement offer was for a single undissected amount, rather than for a total of itemised amounts, and that it would have been unacceptable to determine the character of the receipt in the hands of the recipient by taking into account the uncommunicated reasoning of the payer.

The court stated that no apportionment is appropriate if the receipt is in respect of a claim, or claims, for unliquidated damages only, and is made, or accepted, under a compromise that treats it as a single undissected amount of damages.

However, the court also stated that a single receipt of a mixed nature may be apportioned across the several heads to which it relates, and an income or non-income nature may be attributed to those heads of claim. This apportionment may be done if the amount is ‘in settlement of distinct claims of which some at least are liquidated’, or are otherwise ascertainable by calculation.

Paragraph 196 of TR 95/35 explains that the Commissioner does not consider the relevant case law to preclude a proportionate approach to identifying and allocating amounts of compensation to the various heads of claim if the taxpayer receives a single undissected lump sum in satisfaction of those claims.

What if the lump sum payment is unable to be allocated on any reasonable basis?

If, however, the compensation is unable to be allocated on any reasonable basis then the Commissioner will regard the whole amount of compensation as relating to the disposal of the right to seek compensation. Accordingly, if the compensation relates to a number of heads of claim, or causes of action, but the individual components of the compensation cannot be determined or estimated, no part of the compensation can be said to relate to any particular claim. This means, for example, that if the total claim includes some personal injury elements as well as other elements, the CGT exemption which would otherwise be available under section 118-37(1) of the ITAA 1997 would not apply to any part of the compensation.

The ruling acknowledges, however, that it is likely that some information will be available when a compensation claim is made which can be used to dissect a lump sum amount of compensation. Alternatively, the components of the lump sum ordinarily are able to be estimated or valued on a reasonable basis.

In some circumstances a single receipt of a mixed capital and income nature may be apportioned between capital and ordinary income respectively. Such a receipt cannot, however, be thus apportioned where the payment is in respect of a claim, or claims, for unliquidated damages only, and is made under a compromise that treats it as a single, undissected amount of damages.

Where the compensation receipt is a lump sum that includes unliquidated damages, the question is whether, from the matrix of surrounding facts, there is any basis for apportionment.

The CGT provisions treat the right to sue for damages (or the right to give up the right to sue) as an asset, which can be disposed of by obtaining an award of damages, or by accepting a settlement amount.

Paragraph 69 of TR 95/35 states that the particular asset of which compensation has been received by the taxpayer may be:

1. An underlying asset;

2. A right to seek compensation; or

3. A notional asset.

Underlying asset

Paragraph 70 of TR 95/35 explains that to identify the underlying asset or relevant asset it is appropriate to adopt a 'look-through' approach. The underlying asset is the asset that has been 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.

In Sommer v. FC of T (2002) ATC 4815; (2002) 51 ATR 102, 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.

Disposal of the right to seek compensation

The right to seek compensation is the right of action arising at law or in equity on the occurrence of any breach of contract, personal injury or other compensable damage or injury. The right to seek compensation is an asset for CGT purposes.

TR 95/35, paragraph 11 says that for the amount to be seen as the disposal of the right to seek compensation, the compensation is not to be received in respect of any underlying asset.

In many cases there is both an underlying asset and a right to seek compensation. Determining the most relevant asset depends on whether the underlying asset has been permanently damaged or permanently reduced in value. If the underlying asset has not been affected in that way and there is no disposal or part disposal of the underlying asset, the compensation must be received for the surrender of the right to seek compensation.

Your position is that

You believe that the compensation amount is a CGT asset as it is to recover damages in relation to

● Replacement infrastructure and loss of income and (revenue)

● Ending the right to seek compensation (capital)

The partnership was offered a lesser amount as a lump sum payment in full settlement without knowing the basis of the calculation of the sum offered.

The Deed of Settlement does not provide a breakdown of the settlement amount.

Apportionment cannot be made on a reasonable basis.

Therefore, as the amount is comprised an undissected aggregation of both income and capital, and cannot be apportioned, it should be treated as capital.

In your situation

In the Deed of Settlement between the partnership and the company it states that you allege the infrastructure was defective and the partnership has suffered various losses as a result.

You argued that the amount comprised an undissected aggregation of both income and capital, and therefore should be treated as capital.

TR 95/35, paragraph 11 says that for the amount to be seen as the disposal of the right to seek compensation, the compensation is not to be received in respect of any underlying asset.

In many cases there is both an underlying asset and a right to seek compensation. Determining the most relevant asset depends on whether the underlying asset has been permanently damaged or permanently reduced in value. If the underlying asset has not been affected in that way and there is no disposal or part disposal of the underlying asset, the compensation must be received for the surrender of the right to seek compensation.

In your case when we apply the “look through” approach, and seek the information in the original Summary of Claim, we see that the claim consists only of loss of revenue, unrealised savings, and increased costs, all of which stem from the defective infrastructure – the underlying asset.

The defective infrastructure warrants replacing according to the Statement of claim, and this disposal of the underlying asset suggests that the compensation is for the defective system and the loss of income rather than from the surrender of the right to seek compensation.

The costs involved with the replacement of the asset, loss of income and anticipated saving affect the economy of the farm and in your case reduce the profits. I refer to Griffith CJ ‘s comments in Meeks “The damages received as compensation for non-performance of a business contract stand on the same footing as the profits for the loss of which the damages are paid.”

These claims of reduction in production are similar to the cases above that the courts have held to be revenue in nature.

In addition to the above it is considered that the payment received is not an undissected lump sum. As mentioned previously, it has been argued that ‘the mere fact that compensation has been awarded as a lump sum, and has not been dissected into its component elements’, is a sufficient reason to treat the whole receipt as one of capital.

However, the ATO does not accept the above argument per se. In the Commissioner’s view, the facts and circumstances surrounding the receipt may still enable an apportionment of the lump sum payment on a ‘reasonable basis’ into its constituent elements.

The effect of TR 95/35, as applied to the ITAA 1997, is that if compensation relates to a number of heads of claim, section 116-40 of the ITAA 1997 requires the taxpayer to apportion the compensation on a ‘reasonable basis’ to each of those claims.

However, TR 95/35 also states that, if the taxpayer cannot, or does not, make a reasonable estimate, valuation, or calculation of the amounts that are reasonably attributable to each claim, the ATO will make the allocation using the information that is available in relation to those claims.

In this case, the claim related to multiple heads of claim in which you produced a document that dissected each portion of the claim, even though you did not receive the full amount that you sought it is considered that you would be able to apportion the settlement amount you did receive against the heads of claims.

This is in accordance with what the courts have stated where a single receipt of a mixed nature may be apportioned across the several heads to which it relates, and an income or non-income nature may be attributed to those heads of claim.

The Commissioner would accept if the compensation relates to a number of heads of claim, or causes of action, but the individual components of the compensation cannot be determined or estimated, no part of the compensation can be said to relate to any particular claim. However in your case the compensation components can be determined as each component of the heads of claim was calculated in the court proceedings. This is evidenced in the document you provided titled “The Amended Statement of Claim” dated DDMMYY.

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).