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Ruling

Subject: Lump sum payment

Question

Is the lump sum payment received in relation to the income protection policy assessable as ordinary income?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

You have an income protection policy for your employees.

Several years ago an employee suffered a medical condition and as a result you became entitled to the payment of moneys under the policy.

You receive any payments in relation to the policy and then use these amounts to pay your employee.

The employee was able to continue work soon after, however on restricted duties.

The insurer later undertook a review of policy payments. They were seeking to vary the amounts being paid moving forward.

You advised that the review process was tedious, lengthy and stressful.

The review resulted in a minor annual adjustment; however, the insurer continued to accept that you were entitled to continue receiving payments under the policy.

You did not lodge a dispute in relation to the payments under the policy.

You were subsequently offered a limited time once only opportunity to settle your policy via a lump sum payment.

The offer was accepted.

You received and agreed to a lump sum payment as full settlement and final satisfaction of the income protection policy.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

Reasons for decision

Summary

The lump sum payment received under the income protection policy is assessable as ordinary income in the year it is received. Such a payment is revenue in nature.

Detailed reasoning

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Based on case law, it can be said that ordinary income generally includes receipts that:

o are earned,

o are expected,

o are relied upon, and

o have an element of periodicity, recurrence or regularity.

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

o it is made in substitution of income,

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

o 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 (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443;10 ATD 82). 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 79 ATC 4641; (1979) 10 ATR 411).

Therefore periodic payments received during a period of total or partial disability under an income protection policy are assessable on the same principle as salary and wages. This is because the benefits are a replacement of employment income during the period of total or partial disability (FC of T v. D.P. Smith 81 ATC 4114; (1981)11 ATR 538).

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 all outstanding 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), or

· 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.

· It is well established that, in general, insurance moneys are received on revenue account where the purpose of the insurance was to fill the place of the revenue receipt which the event insured against has prevented from arising (Carapark Holdings Ltd v. Federal Commissioner of Taxation (1967) 115 CLR at 633).

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.

This is consistent with the approach taken by the Commissioner in Taxation Determination TD 93/3 which deals with the partial commutation of periodic payments to a lump sum. As outlined in paragraph 4 of TD 93/3, such a commutation would result in the lump sum remaining assessable, as its effect was simply to pay in advance the future weekly payments.

This view has also been confirmed in Sommer v. FC of T 2002 ATC 4815; 51 ATR 102 (Sommer's case). The case involved a medical practitioner who had taken out an income protection policy. Following the rejection of the taxpayer's claim for income replacement payments of $4,000 per month, the matter was settled out of court with the taxpayer receiving a lump sum.

The taxpayer argued that the amount was a payment of capital as it was paid in the consideration of the cancellation of the policy, and the surrender of his rights under it or that the payment was capital as it was an undissected aggregation of both income and capital.

In dismissing the taxpayer's appeal it was held that the payment was in settlement of income claims of the taxpayer in circumstances where the purpose of the insurance policy was to fill the place of a revenue receipt. As a result, the payment was clearly on revenue account. The fact that the payment was received in one lump sum did not change its revenue character.

In your case, the income protection policy provides you with regular receipts which you then use to make payments to your employee in the event of their illness or disability. As you rely on these receipts to make payments to your employee which substitute for their salary or wages, we consider them to be ordinary income and are included in assessable income under section 6-5 of the ITAA 1997.

You were offered a lump sum payment in full settlement of the policy. That is, the future regular payments were commuted to a lump sum. As the periodic payments are ordinary income, the lump sum payment also retains the character of being ordinary income.

It is acknowledged that in accepting the lump sum you have given up your rights for future claims in relation to the policy. However, it is considered that your case is similar to Sommer's case and the lump sum represents a redemption of the right to receive income and is also regarded as income in nature.

The fact that the income benefits under the policy was made in one lump sum does not change the revenue character of the receipt as it was essentially designed to compensate you in respect of your income claims, or was a payment in substitution of those claims. Also the fact that the basis of the calculation of the lump sum can not be determined does not change the character of the payment.

Consequently, the lump sum finalisation payment which relieves the obligation to make future payments to you retains its character of ordinary income and is assessable under section 6-5 of the ITAA 1997.