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Ruling

Subject: Compensation income

Questions and answers:

Will the lump sum received for your personal injury settlement or any portion thereof be ordinary income?

No.

Will any capital gain arising from the compensation amount be disregarded?

No.

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts

You received a lump sum payment for personal injury.

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 Subsection 6-15(1)

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

Reasons for decision  

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 generally been held to include 3 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.

The compensation offered to you is not income from rendering personal services, income from property or income from carrying on a business.

The payment is also a one off payment and thus it does not have an element of recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

Your compensation claim was to replace lost income, reimburse previous and future medical expenses and contained a capital receipt, being the pain and suffering component of your claim. As such, it is necessary to consider whether the payment could be dissected into assessable and non-assessable components.

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 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.

Consequently, where you receive an undissected lump sum which includes assessable and non-assessable components that cannot be identified or quantified, the whole of the lump sum amount is not treated as ordinary income.

The offer that was accepted has no identifiable or quantifiable components in the lump sum payment you received.

As the lump sum payment to you would comprise compensation for a mixture of income and capital items and the payment cannot be dissected into its constituent parts, the whole amount would be deemed to be of a capital nature. Therefore, the lump sum amount is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Capital gains

The right to seek compensation is considered to be a CGT asset.

Section 104-25(2) of the ITAA 1997 discusses that that the CGT event does not happen when you acquire the right to seek compensation, it happens when there is a cancellation, surrender or similar ending. This is a C2 event.

Paragraph 11 of TR 95/35 advises that:

If any compensation is not received is respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right.

Settlement of your statement of claim in 2010 resulted in CGT event C2 happening.

You received consideration for the disposal as an undissected lump sum payment of $X; with you receiving $X in 2010.

Paragraph 21 of TR 95/35 provides guidance if undissected lump sum compensation payments are received for a number of claims, including a personal injury claim, and its individual components cannot be determined, or reasonably estimated, and no part of the compensation can be quantified as relating to the personal injury of the taxpayer. Accordingly, as an undissected lump sum payment can not be apportioned, there is no exemption applicable to any part of the compensation received in consideration of the disposal of the right to seek compensation.

A CGT event occurred in relation to your right to seek compensation when your claim was settled. The payment was undissected; with no ability to determine or estimate any part of the compensation payment relating to your personal injury. It therefore follows the amount has been received for the disposal of the right to seek compensation and is assessable under CGT provisions. No exemption is available where the payment is undissected and the capital gain made upon receipt of the payment can not be disregarded.

You are required to declare your compensation payment in your income tax return as a capital gain.

This payment will be taxed at your marginal tax rate.