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Ruling

Subject: Assessability of benefits paid under the trauma feature of an income protection policy

Question 1

Are the benefits paid to you under the trauma feature of your income protection policy assessable income?

Answer

No.

Question 2

Will any capital gains tax arising from the payment of the benefits under the trauma feature of your income protection policy be disregarded?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You have an insurance plan with an insurance company, which is one of a range of plans that can be tailored to meet personal insurance needs. The plan that you have is an income protection plan, which has a trauma feature.

You are the plan owner and the insured person under the above insurance plan.

The insurance package that you took out includes cover for income protection and trauma (under the trauma feature applicable to your plan).

The trauma feature of your plan provides for the payment of a 'benefit' periodically for a specified period of time, if the insured person (you) suffers any of the listed trauma conditions or undergoes any of the listed medical procedures.

The 'benefit' payable on your plan is the maximum benefit amount that you applied for and the insurance company accepted, as specified in your policy.

The trauma conditions listed in your policy are a specific range of medical conditions.

The benefits under the trauma feature of your plan are payable for the specified period even if the insured person (you) can work. They are payable even if the insured person (you) does not stop working.

Under the trauma feature, the insurance company only pay once for each trauma condition and medical procedure. You can make more than one claim under the trauma feature as long as each claim is for a different trauma condition or medical procedure.

In a previous income year you suffered a medical condition, which was one of the trauma conditions listed in your policy.

During the income year you were diagnosed with a reoccurrence of the above medical condition.

You lodged a claim with the insurance company under your income protection policy during the income year.

During the income year the insurance company advised you that your claim was accepted from the date of the initial diagnosis of the medical condition (in a previous income year), under the trauma feature of your policy. A lump sum amount was paid to you for benefits due for the specified period from the date of the initial diagnosis.

You did not make a claim with the insurance company when you had the initial diagnosis of the medical condition in a prior income year, as you were not aware you could claim. It was not until later, when you were diagnosed with the reoccurrence of the medical condition, that you made a claim. The insurance company then paid you the trauma benefits in one lump sum, rather than in periodic payments over the specified period, as the benefits related to a period that had already passed.

Your claim under the trauma feature of your policy was finalised effective from the end of the specified period over which benefits were payable.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-1(1)

Income Tax Assessment Act 1997 Subsection 6-15(1)

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 1936 Section 27H

Income Tax Assessment Act 1997 Section 15-30

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 100-20

Income Tax Assessment Act 1997 Section 108-5

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

Reasons for decision

Summary

The payment of benefits that you received under the trauma feature of your income protection policy is not ordinary income and it is not statutory income. Consequently, it is not assessable income. As the payment was received as compensation for an injury or illness you suffered personally, any capital gain or loss is disregarded.

Detailed reasoning

Subsection 6-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that assessable income consists of ordinary income and statutory income.

If an amount is not ordinary income and is not statutory income it is not assessable income, so you do not have to pay income tax on it (subsection 6-15(1) of the ITAA 1997).

Ordinary income

Ordinary income is income according to ordinary concepts (section 6-5 of the ITAA 1997).

Ordinary income has generally been held to include three categories: income from rendering personal services, income from property and income from carrying on a business.

The courts have identified a number of factors which indicate whether an amount has the character of income according to ordinary concepts.

A frequent characteristic of income receipts is an element of periodicity, recurrence or regularity (FCT v. Dixon (1952) 86 CLR 540; (1952) 10 ATD 82).

One or more of the following characteristics will combine with periodicity to give an amount an income nature:

· it is made in substitution of income

· it is made to provide financial support, for example, as an income supplement

· it is received in circumstances where the recipient has an expectation of receiving the payment on a regular basis so that the recipient is able to depend upon the payment for his or her regular expenditure.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted or designed to replace. If the compensation is paid in substitution of income, it will generally be income in nature. For example, compensation payments such as workers compensation, which substitute income, have been held by the courts to be income under ordinary concepts (FC of T v. Inkster (1989) 20 ATR 1516; 89 ATC 5142).

On the other hand, 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. For example, compensation for the deprivation or impairment of earning capacity (that is, the loss of earning capacity) is not a payment in substitution for lost earnings. Earning capacity s a capital asset and therefore compensation for the loss of earning capacity is capital in nature, rather than income in nature (FCT v Slaven, 84 ATC 4077; 15 ATR 242 and Taxation Ruling IT 2193).

Periodic payments received by a taxpayer during a period of disability under a personal accident, income protection or disability insurance policy taken out by the taxpayer are assessable on the same principle as workers compensation, that is, they are assessable where they are paid to replace lost earnings (FC of T v. DP Smith 81 ATC 4114; (1981)11 ATR 538 (DP Smith)).

Although a lump sum payment under a personal accident, income protection or disability insurance policy is not a periodic payment the above principle may also apply to a lump sum paid to settle 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.

Taxation Determination TD 93/58 explains the circumstances in which a lump sum compensation/settlement payment is assessable, and states that such a payment is assessable income:

· if the payment is compensation for loss of income only (even when the basis of the calculation of the lump sum cannot be determined)

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

In your case, the benefits that you received under the trauma feature of your income protection policy were not income from rendering personal services, income from property or income from carrying on a business. Rather, the benefits were paid as a result of you suffering from a specified trauma condition.

The trauma feature of your income protection plan provided for the payment of a periodic benefit for a specified period of time. Although the payment that you received from the insurance company in the income year under the trauma feature of your policy was made in one lump sum, this was because the trauma benefits related to a period that had already passed. The payment that you received was for the periodic benefits due during the specified period after your medical condition was initially detected, and therefore has an element of periodicity. It is necessary to consider whether this element of periodicity characterises the payment as ordinary income.

Product Ruling PR 2007/20 sets out the Commissioner of Taxation's view on the payment of insurance benefits that are the 'instalment benefit payment type' (monthly benefits required to be paid in instalments over a specified period), to individuals who are policy owners under the OneCare policy offered by ING Life Limited in respect of life cover, total and permanent disability (TPD) cover and/or trauma cover.

The ING Life OneCare policy offers a range of insurance covers including life, TPD and trauma. The benefits (the insured amount) under the OneCare policy are paid for trauma cover when the life insured suffers a specified trauma condition. The insured amount is an amount agreed between the policy owner and ING Life, payable upon the happening of a specified event. Under the 'instalment benefit payment type', ING Life is required to pay the insured amount on a monthly basis over a payment term specified in number of years (for example, 3, 5 or 10 years) or age based (payment term calculated by reference to age).

A feature of the OneCare policy is the requirement on the policy owner to nominate one of the two benefit payment types that is to apply should the insured amount become payable under the life, TPD or trauma covers. These are either the 'instalment benefit payment type' or the 'lump sum benefit payment type'. The benefit payment type can be changed upon request, but subject to ING Life's agreement. The benefit payment type however, cannot be changed at the time of a claim or at any time when entitlement to make a claim arises.

PR 2007/20 states that under the OneCare policy the lump sum payable under the life, TPD and trauma covers is intended not to compensate for the loss of earnings but for the loss of earning capacity of the insured, and would therefore not be ordinary income. The Product Ruling considers the issue of whether the option to convert the lump sum payment into regular or periodic payments alters the character of the receipts to that of ordinary income. It states that the calculation of the payments under the 'instalment benefit payment type' has no relationship to the amount of earnings of the policy owner, and can be distinguished from the insurance payments received by the taxpayer in DP Smith. In DP Smith the taxpayer had taken out a personal disability insurance policy which was to provide a monthly indemnity against the income arising from the inability to earn.

PR 2007/20 states that the payments under the 'instalment benefit payment type' are not paid to compensate for loss of earnings but for the loss of earning capacity, and that the payments are capital in nature. Accordingly, the 'instalment benefit payment type' payments under the life, TPD and/or trauma covers are capital receipts and are not assessable as ordinary income under section 6-5 of the ITAA 1997.

Your income protection plan (with trauma feature) is similar to the ING Life OneCare policy. Benefits payable under the trauma feature are payable in periodic instalments over a specified period, and are payable even if the insured person (you) does not stop working. Therefore, the reasoning in PR 2007/20 applies.

The payment under the trauma feature of your income protection policy was not paid to compensate for loss of earnings. It was payable to you even if you did not stop working. Rather, you received the payment for the loss of a capital asset, that is, your capacity to earn income because you suffered a trauma event. The payment is a capital receipt and is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997). Section

10-5 of the ITAA 1997 lists those provisions.

The specific statutory income provisions that are relevant to your circumstances are:

· annuities (section 27H of the Income Tax Assessment Act 1936 (ITAA 1936))

· insurance or indemnity payments (section 15-30 of the ITAA 1997)

· capital gains (section 102-5 of the ITAA 1997).

Annuities

Section 27H of the ITAA 1936 includes in assessable income the amount of an annuity derived by a taxpayer.

PR 2007/20 states that the terms of the OneCare policy (under the life cover, trauma cover and TPD cover) provide that upon the happening of a specified event ING Life has a liability to make a payment to the policy owner. It states that the mere fact that the liability has to be paid out in instalments does not convert the payments into annuity payments. It states that the insured amount which is the source of the instalment payments represents a debt owed by the insurance company to the policy owner. The payments under the 'instalment benefit payment type' are not an annuity and are not assessable under section 27H of the ITAA 1936.

Similarly, the benefits payable under the trauma feature of your income protection policy are not considered to be an annuity, and so are not assessable under section 27H of the ITAA 1936.

Insurance or indemnity payments

Section 15-30 of the ITAA 1997 operates to include in a taxpayer's 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 in the taxpayer's assessable income, and the amount received is not assessable as ordinary income.

The payments under the trauma feature of your policy are for the loss of your earning capacity, and not for the loss of income. A person's earning capacity is a capital asset, so any payment received to compensate for that loss is also of a capital nature and does not fall to be assessed under section 15-30 of the ITAA 1997.

Capital gains tax (CGT) provisions

Section 102-5 of the ITAA 1997 provides that assessable income includes any net capital gain (the total of capital gains for the income year, reduced by certain capital losses).

You can make a capital gain (or loss) only if a CGT event happens (section 100-20 of the ITAA 1997). Most CGT events involve a CGT asset, which is defined in section 108-5 of the ITAA 1997 as:

· any kind of property

· a legal or equitable right that is not property.

· Taxation Ruling TR 95/35 considers the CGT consequences for a person who receives an amount as compensation. The ruling states that a right to seek compensation is an asset for the purposes of the CGT provisions, and that a right to seek compensation is:

· acquired at the time of the compensable wrong or injury

· disposed of when it is satisfied, surrendered, released or discharged.

TR 95/35 discusses compensation received under a policy of insurance, and states that an insured's right of indemnity under an insurance policy is a right to seek compensation.

In your case, the right of indemnity under the trauma feature of your income protection insurance policy was acquired when the triggering event of the policy occurred, that is, when you were diagnosed with the medical condition. The payment of the claim by the insurance company resulted in the disposal of your right of indemnity. This disposal of your right to seek compensation gives rise to a CGT event.

However, paragraph 118-37(1)(b) of the ITAA 1997 allows you to disregard a capital gain or loss you make from a CGT event relating to compensation you receive for any wrong, injury or illness you suffer personally.

Therefore, any capital gain (or loss) that you may have made from disposing of your right to seek compensation from the insurance company under the trauma feature of your insurance policy is disregarded under paragraph 118-37(1)(b).

Conclusion

The payment of benefits that you received from the insurance company under the trauma feature of your income protection policy is not ordinary income and it is not statutory income. Consequently, it is not assessable income (subsection 6-15(1) of the ITAA 1997).