Edited version of private ruling

Authorisation Number: 1011814642048

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Ruling

Subject: Compensation of income benefits - assessable income and capital gains tax liability

Question 1

Is the compensation payment received under a Deed of Release assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is any capital gain or loss made upon receipt of a compensation payment under a Deed of Release disregarded under section 118-37(1)(b) of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commences on:

I July 2010

Relevant facts and circumstances

You entered into an income protection insurance policy with an insurance company

Terms of the policy, inter alia, were that:

(a) the insurance company would pay you the amount of the fortnightly benefit plus any increases for indexation under Condition 3.3 if you suffered for Total Disablement for longer than the waiting period (3.1.1);

(b) Total Disablement meant you were, by reason of injury or sickness:

(1) unable to perform at least one of the duties of your occupation necessary to produce income;

(2) not working in any occupation; and

(3) under the care of a medical practitioner.

(d) "Sickness' meant illness or disease.

(e) waiting period was 30 days;

(f) fortnightly benefit in October 2003 was for a specified amount; and

(k) the benefit period was to age 60.

You are under 65 years of age.

You were employed as in a specific and particular field for a number of years.

You suffered from a disorder during this period of employment. The illness prevented you from working for a substantial period of time. You were paid total disability payments through an income protection policy held with the insurer.

When you attempted to return to work your employment was terminated.

You were unable to return to your usual occupation and since this time have obtained some casual work.

Your claim for total disability insurance benefits through the insurer for the period specified in your claim was denied.

You undertook legal action. You provided a copy of the writ between yourself and the insurer indentifying the proceedings docket number.

As a result of the legal action undertaken, you received a lump sum amount which was paid as per the Deed of Release and included costs and interest. A sum was paid to your bank account with the balance paid to your solicitors. You provided a copy of the Release Agreement between yourself and the insurer detailing the terms of payment.

You contend that the payment was made as compensation to surrender your rights of benefits under the insurer's income protection insurance policy.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5,

Income Tax Assessment Act 1997 Section 6-10,

Income Tax Assessment Act 1997 Section 10-5,

Income Tax Assessment Act 1997 Section 118-20,

Income Tax Assessment Act 1997 paragraph 118-37(1)(b),

Income Tax Assessment Act 1936 subsection 25(1),

Reasons for decision

Question 1

Section 6-5 of the ITAA 1997

Ordinary income

Section 6-5 of the ITAA 1997 deals with receipts of ordinary income. 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.

Periodic payments during a period of total or partial disability under a personal accident or disability insurance policy are assessable on the same principle as workers' compensation payments. Weekly or periodic workers' compensation payments (or periodic payments under other legislation) for loss of salary, either whole or in part, are assessable as ordinary income. The intention in taking out the income protection policy is to protect and provide income in the event of illness or disability.

Undissected payments

When considering the treatment of undissected lump sum payments, McLaurin v. Federal Commissioner of Taxation (1961) 104 CLR 381; (1961) 12 ATD 273; (1961) 8 AITR 180 and subsequently Allsop v. Federal Commissioner of Taxation (1965) 113 CLR 341; (1965) 14 ATD 62; (1965) 9 AITR 724 raised the proposition that where a lump sum compensation payment can be dissected into its constituent income and capital components, the income components may be assessable. The Commissioner confirmed this view in Taxation Determination 93/58 (TD 93/58) and indicated that any part of a lump sum compensation amount will only be assessable as ordinary income:

(a) if the payment is compensation for loss of income only; or

(b) to the extent that a portion of the lump sum is identifiable and quantifiable as income. This is possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

This view is further confirmed in the Federal Court case, Sommer v FC of T 2002 ATC 4815; 51 ATR 102 (Sommer case) from a decision of the Administrative Appeals Tribunal (AAT).

The case involved a medical practitioner who had taken out a Professional Income Replacement insurance policy. Following rejection of the taxpayer's claim for income replacement payments of $4,000 per month, the matter was settled out of court with the payment of a lump sum to him. The taxpayer argued that the amount was capital as it was paid in consideration of the cancellation of the policy and the surrender of his rights under it. Alternately, he argued that the amount comprised an undissected aggregation of both income and capital and therefore should be treated as capital.

In dismissing the taxpayer's appeal it was held that:

1. The terms of the agreement referred to the relevant surrounding circumstances. Accordingly, it was difficult to argue that the surrounding circumstances were not relevant to the characterisation of the settlement amount. The true nature and proper characterisation of the settlement amount was to be determined by having regard to the policy, the taxpayer's claims under the policy, the terms of settlement which settled those claims, and the rights the taxpayer would be surrendering upon cancellation of the policy.

2. The fact that the payment of the monthly benefits was made in one lump sum did not change the revenue character of the receipt if it was essentially designed to compensate the taxpayer in respect of his income replacement claims or was a payment in substitution of those claims. The substance and commercial reality of the settlement was that it was a full and final settlement of the dispute between the taxpayer and the insurer in relation to the taxpayer's past and future claims to be entitled to income replacement benefits as a result of his disability since August 1996.

3. As the settlement amount did not relate to claims, entitlements, or benefits of an income and capital nature the question of apportionment did not arise.

Applying the decision in McLaurin to your case, your payment amount cannot be apportioned. Rather this amount is a single undissected lump sum. Your 'statement of claim' did include benefits of an income nature and the undissected lump sum payment was not based on a mixture of income and capital items. The settlement was made as a full and final settlement of the dispute between yourself and the insurer and released both parties from any past and future claims under the disputed policy.

Capital vs Revenue

FCT v Slaven 84 ATC 4077 (Slaven case) sought an appeal of the decision reported at 83 ATC 4387 treating compensation payments as assessable income. The appeal was dismissed with the Supreme Court holding that the payments made to compensate the taxpayer for the loss of a capital asset (her earning capacity) and that consequently the payments were non-assessable capital receipts in her hands and were not assessable either under subsection 25(1) or 26(j) of the ITAA 1936. The Commissioner appealed to the Full Federal Court contending that the payments were income according to ordinary concepts and assessable under subsection 25(1) of the ITAA 1936 as income derived by the taxpayer. The payments were said to have been made and received for the purpose of providing recoupment of income lost by the taxpayer. Whilst the appeal was dismissed, consideration should be given to the judgement in respect of ATC 4085 as follows:

"The Parliament of Victoria cannot determine by its own legislation whether the receipt of a statutory payment answers the description of income or capital in the hands of the recipient within the meaning of sec. 25 of the Assessment Act, a Commonwealth Act. But the purpose of a statutory payment, as disclosed by the terms of the statute itself, must be a powerful, though not conclusive, aid to the determination of the character of the payment and in particular as to whether its receipt constitutes income in the hands of a taxpayer."

In the Slaven case, the claim was in relation to the taxpayer's capacity to earn assessable income, the capital asset, rather than the actual income forfeited, as revenue resulting from the capital asset. It therefore follows that the compensation payment received was of a capital nature. However, in your case, your claim was for the fortnightly benefits denied by the insurer and not the capital asset of your ability to earn assessable income. It therefore follows that your lump sum payment was revenue based and assessable as ordinary income under section 6-5 of the ITAA

Summary

In your circumstances, the relevant facts that apply to your case are similar to those found in the Sommer case. Your undissected lump sum was paid in full settlement of your claim for fortnightly benefits under an income protection insurance policy as a result of the loss of your income stream due to your adjustment disorder. The payment is fully assessable as ordinary income under section 6-5 of the ITAA 1997.

Question 2

Paragraph 118-37(1)(b)

We have determined that your lump sum payment is assessable income under section 6-5 of the ITAA 1997. Any capital gain will not be assessed under paragraph 118-37(1)(b) of the ITAA 1997 as anti-overlap provision prevents double taxation. Your compensation payment was paid to settle legal proceedings with no admission of liability made by the insurer. We consider that the payment did not relate to any wrong, injury or illness you or your relative suffered personally but to the payment of the lost income stream.

Note:

Had the lump sum payment been assessable under paragraph 118-37(1)(b) of the ITAA 1997 any capital gain you make from a capital gains tax (CGT) event is reduced if, because of the event, a provision of the ITAA 1997 (outside of this Part) includes an amount, for any income year, in:

(a) your assessable income.