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Ruling

Subject: Ex gratia payment

Question

Is an ex gratia payment received in settlement of a legal action subject to income tax?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts and circumstances

You took legal action against your employer. Your claim may be settled by way of a deed of release under which you will receive an ex gratia payment of the settlement sum plus accrued and untaken annual leave entitlements. In both cases applicable taxation withholding is to be deducted from the amounts payable.

You resigned from your employment prior to receiving the settlement offer.

The draft deed provides for the mutual release of both parties from any or all present and future claims involving allegations concerning the employment.

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 82-130

Income tax Assessment Act 1997 Section 82-135

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that assessable income includes income according to ordinary concepts which is called ordinary income. Section 6-10 of the ITAA 1997 provides that your assessable income includes some amounts that are not ordinary income. This income is described as statutory income. A summary of the various statutory income provisions is found at section 10-5 of the ITAA 1997.

An ex gratia payment payable by your employer in settlement of a dispute is not ordinary income but consideration must be given as to whether such a payment is statutory income. Section 10-5 of the ITAA 1997 refers to employment termination payments that are assessable under Division 82 of the ITAA 1997.

A payment made to an employee on or after 1 July 2007 is an employment termination payment (ETP) if the payment satisfies all the requirements in section 82-130 of the ITAA 1997, and is not specifically excluded under section 82-135 of the ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's employment; and

(b) it is received no later than 12 months after the termination (but see subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

Sub section 82-130(4) of the ITAA 1997 provides two exceptions whereby the Commissioner may determine that:

· the payment is a genuine redundancy payment or an early retirement scheme payment; or

· by legislative instrument paragraph (1)(b) does not apply .

Neither of these exceptions applies in your case.

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the words have been interpreted by the courts in several cases. The Commissioner has also issued Taxation Ruling TR 2003/13 which discusses the meaning of the phrase.

The Full High Court considered the expression 'in consequence of' in Reseck v. FC of T (1975) 133 CLR 45; (1975) 6 ALR 642; (1975) 49 ALJR 370; (1975) 5 ATR 538; (1975) 75 ATC 4213 (Reseck). Justice Gibbs stated:

Within the ordinary meaning of the words a lump sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination… It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment.

While Justice Jacobs stated:

It was submitted that the words 'in consequence of' import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a 'following on'.

In looking at the phrase 'in consequence of' the Full Federal Court in McIntosh v. FC of T (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325 (McIntosh) considered the decision in Reseck. Justice Brennan stated:

Though Jacobs J. speaks in different terms, his meaning may not be significantly different from the meaning of Gibbs J... His Honour denies the necessity to show that retirement is the dominant cause, but he does not allow a temporal sequence alone to suffice as the nexus. Though the language of causation often contains the seeds of confusion, I apprehend his Honour to hold the required nexus to be (at least) that the payment would not have been made but for the retirement.

The Commissioner in TR 2003/13 considered the phrase 'in consequence of' as interpreted by the Courts.

Paragraph 5 of TR 2003/13 states:

…the Commissioner considers that a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

Where, under a deed of release, before any payment is payable the taxpayer is required to resign from employment, it has been held that a payment not paid specifically in relation to that termination is, nevertheless, also an ETP.

In your case, there was a dispute between you and your employer. You terminated your employment with your employer prior to making a claim.

Subsequently the employer made an offer to pay you a lump sum to enter into a mutually agreed deed of release.

The Courts have held that settlement amounts arising from actions that are in some manner connected with the termination of employment are payments made in relation to the taxpayer in consequence of the termination of their employment.

Although the dominant cause of the payment is to settle the claim initiated by you, there is, at least, a causal connection between the termination of employment and the proposed payment. Given the nature of this matter, the dispute, the settlement, the termination of employment and the offer of payment are all intertwined and connected.

Based on the principles stated in Reseck and McIntosh and the Commissioner's views expressed in TR 2003/13, the facts presented demonstrate that a clear connection exists between the termination of your employment and the settlement sum.

Taxation Ruling IT 2424 deals with compensation payments in respect of unlawful acts of discrimination. It states the following regarding sexual harassment:

In cases of sexual harassment compensation may be paid for injury such as psychological and emotional injury, injury to feelings, humiliation and embarrassment, loss of self-esteem, anxiety or distress, loss of enjoyment of life, etc. A payment to compensate an employee for injury of this kind is not liable to income tax.

As the settlement sum will be payable under the draft deed without admission of liability by any party and as the sum is to be paid as an ex gratia payment, it cannot be said that the payment is one which specifically relates to any particular claim for harassment.

Consequently, the settlement sum is considered to be an employment termination payment in accordance with subparagraph 82-130(1)(a)(i) of the ITAA 1997 and is included as assessable income.