Edited version of your private ruling

Authorisation Number: 1012150381247

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: Income-settlement payment

Question 1

Is the lump sum payment you have received as a result of an out of court settlement for negligence and breach of contract assessable as ordinary income?

Answer: No

Question 2

Is the lump sum payment you have received as a result of an out of court settlement for negligence and breach of contract considered post judgement interest?

Answer: No

Question 3

Are you entitled to a deduction for legal expenses incurred in relation to your out of court settlement?

Answer: No

Question 4

Is the lump sum payment taxable under the capital gains tax provisions in accordance with Part 3-1 of the Income Tax Assessment Act 1997?

Answer: Yes

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· a private ruling application

· a copy of a statement of claims

· a copy of a settlement agreement

· a copy of the a court order

· a deed of release

You suffered an illness.

You underwent surgery and as a result of medical negligence you were permanently disabled.

You are under the guardianship of an entity.

The entity engaged legal practitioners to undertake legal proceedings against a number of health facilities for negligence.

You were awarded damages and costs a number of years ago from a court for your illness.

You did not receive interest on the costs awarded by the court.

The defendants lodged an appeal against the judgement.

You lodged a cross appeal against the judgement.

The entity retained the legal practitioners for the appeal and cross appeal in relation to the judgement.

You entered into a deed of release to settle the appeal and cross appeal with the defendants.

By entering into the deed of release the parties will do all such things as may reasonably be necessary to secure the dismissal of both the appeal and cross appeal.

The entity took legal action against legal practitioners for:

· damages

· for breach of contract

· for negligence

· misleading and deceptive conduct

· interest

· costs

· such further or other costs or relief as the court deems fit.

You entered into an agreement with the legal practitioners and received a lump sum payment.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-1

Income Tax Assessment Act 1997 section 51-57

Income Tax Assessment Act 1997 section 51-57

Income Tax Assessment Act 1997 subsection 102-5(1)

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 112-15

Income Tax Assessment Act 1997 section 115-10

Income Tax Assessment Act 1997 section 115-15

Income Tax Assessment Act 1997 section 115-20

Income Tax Assessment Act 1997 section 115-25

Income Tax Assessment Act 1997 section 115-100

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 118-37

Reasons for decision

Ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (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.

The lump sum payment 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 as such it does not have an element of recurrence or regularity. Although the payment may be expected, and perhaps relied upon, this expectation arises from the settlement of a legal dispute in relation to damages as a result of breach of contract and negligent advice provided by your legal practitioners regarding a personal injury claim rather than from a relationship for personal services performed.

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. 

Taxation Determination TD 93/58 indicates that where a taxpayer receives an undissected lump sum which includes assessable and non-assessable components that cannot be identified or quantified, the whole of the lump sum is treated as a non-assessable amount.

You received a lump sum payment for damages and costs as a result of entering into the settlement agreement. As you are unable to dissect the lump sum payment into its various components, the whole amount is deemed to be of a capital nature. Therefore, the lump sum amount is not assessable under section 6-5 of the ITAA 1997 as ordinary income.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income and are also included in assessable income.

You believe the amount received is post-judgement interest as there is sufficient nexus to the settlement payment and the legal action that arose against the defendant as you were entitled to interest when the original judgment was handed down a few years ago.

For an amount to be exempt income as post-judgement interest under section 51-57 of the ITAA 1997 certain conditions need to be met:

The judgment debt arose from a judgment (referred to as the "original judgment") given by or entered in a court for an award of damages for personal injury, and

The amount is in respect of the whole or any part of the period beginning at the time of the original judgment (or, if the judgment debt is taken to have arisen at an earlier time, that earlier time) and ending when the original judgment is finalised.

When is an original judgment finalised?

An original judgment is finalised when any of the following applies:

· where no appeal has been lodged - at the end of the period for lodging an appeal against either the original judgment or a subsequent related judgment

· if an appeal is lodged from either the original judgment or a subsequent related judgment and final judgment on the appeal is given by or entered in a court-when the final judgment takes effect. A judgment is a final judgment if no appeal lies against it or leave to appeal has been refused; or

· if an appeal is lodged from either the original judgment or a subsequent related judgment but it is settled or discontinued - when the settlement or discontinuance takes effect.

In your case, the original judgement was handed a number of years ago which was subsequently appealed by the defendant to which you cross appealed.

You and the defendants entered into the deed of release seeking to do all such things as may reasonably be necessary to secure the dismissal of both the appeal and cross appeal.

The subsequent legal action against the legal practitioners is considered a separate legal action where the amount of damages paid was as a result of breach of contract and negligent advice. While the interest you were seeking to claim was based on interest that may have been payable as a result of the first judgement. The agreed sum does not indentify the various components payable under the settlement order and therefore the whole amount is deemed to be of a capital nature.

The original judgment order was finalised a few years ago and the exemption in regards to any future payment of interest does not apply. Therefore the lump sum payment in not post-judgment interest and is not exempt under section 51-57 of the ITAA 1997.

Legal expenses

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered: Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634, (1946) 3 AITR 436; (1946) 8 ATD 190 (Hallstroms case). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Legal expenses may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's income producing activity (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). Where however, expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible.

In your case, you took legal action to sue the legal practitioners for negligent advice provided in relation to a previous compensation claim. The expenditure incurred in seeking damages for negligence is expenditure of a capital nature. Therefore, the costs you incurred for legal expenses is not deductible under section 8-1 of the ITAA 1997.

Capital gains tax implications relating to compensation receipts

As it is viewed that the settlement amount is capital in nature, it is necessary to consider the capital gains tax (CGT) implications in relation to the receipt of the compensation amount.

Under the CGT provisions, you may make a capital gain or capital loss if a CGT event happens to a CGT asset. To determine any CGT implications in relation to compensation payments you must establish the nature of the asset to which the compensation payment relates.

Taxation Ruling TR 95/35 (TR 95/35) provides the Commissioner's view on the application of the CGT provisions to compensation receipts. Paragraph 69 of TR 95/35 identifies three types of particular assets that compensation may be received for as follows:

1.   an underlying asset;

2.   a right to seek compensation; and

3.   a notional asset.

In TR 95/35 the Commissioner adopts an underlying asset approach, also known as a look-through approach, to the transaction or arrangement which generates the compensation receipt to determine the asset to which the compensation amount is most directly related.

The initial question is whether there is an underlying asset to which the compensation has a direct and substantial link. This requires that there be an asset which has been disposed of and has come to an end, or which has been permanently reduced in value. Under this approach, where there is such an underlying asset which has been disposed of, the Commissioner will treat the compensation as consideration for that disposal.

If the amount of compensation is not received in respect of any underlying asset, then it must be taken into account as to whether the amount relates to the disposal by the taxpayer of the right to seek compensation.

Any capital gain arising on the disposal of that right is calculated using the cost base of that right. TR 95/35 makes it clear that the right to seek compensation is regarded as including all of the rights arising during the process of pursuing the compensation claim.

We have used the look through approach in relation to your situation and it is viewed that there is no underlying asset. While you had undertaken the initial litigation seeking damages for personal injuries you incurred in relation your illness, the litigation from which you received the settlement amount payment related to you seeking compensation for damages, interest and costs due the actions of the defendants. The Deed of Settlement in relation to this litigation outlines that you and the other parties released and discharged all parties from further legal action in relation to the litigation claim. Therefore, the settlement amount relates to your right to seek compensation.

You are taken to have acquired the asset, being the right to seek compensation at the time the damage, monetary loss or injury occurs. If a taxpayer chooses to pursue more than one basis of claim, such as a claim for negligence and a claim for breach of contract, in relation to a single wrong or breach, the right to seek compensation is acquired at the time of the first actionable wrong or breach.

In your case, you acquired your right to seek compensation when the settlement occurred in relation to the first litigation issue a few years ago, when the legal practitioners had failed to advise you about your eligibility for an amount of interest in relation to your original litigation issue.

Since the payment is in relation to the right to receive compensation there is no need to consider the existence of the notional asset.

Paragraph 18 of TR 95/35 outlines that if the amount of compensation received is an undissected lump sum; the whole amount is treated as being consideration received for the disposal of the right to seek compensation.

The Commissioner takes the view that interest awarded as part of a compensation amount is ordinary income of the taxpayer. If the taxpayer receives an undissected lump sum compensation amount and the interest cannot be separately identified and segregated out of that receipt, no part of that receipt can be said to represent interest.

In your case, the settlement payment that was inclusive of your costs in full and final settlement of claims made against the legal practitioners. As the amount of compensation is an undissected lump sum, the whole amount is treated as being consideration received for the disposal of the right to seek compensation.

A CGT asset includes legal or equitable rights that are not property. The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other damage or injury. Therefore, your CGT asset was the right to seek compensation from the defendants. 

CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset being satisfied, surrendered or released. TR 95/35 provides that this occurs when a taxpayer agrees to a release, discharge, satisfaction or surrender of their right to seek compensation. This is generally at the final point of settlement of the claim, whether in the course of Court proceedings, or in an out of Court arrangement. The time of disposal is generally considered to be the time of entering into the settlement agreement and receiving the compensation.

In your case, the order approving the settlement agreement was made and as a result you received the settlement amount as a compensation payment. It is viewed that CGT event C2 occurred when the claim was released.

In accordance with the CGT provisions, you make a capital gain if your capital proceeds are more than your cost base. In your case, your capital proceeds that you received as a result of CGT event C2 occurring when you released your right to seek compensation from the legal practitioners.

The cost base of the right to seek compensation includes the sum of money and the market value of property given as consideration for the creation of the asset. Legal expenses that you have incurred may be included in the cost base. As you did not pay anything to acquire the right to seek compensation, your total cost base will be the amount of legal expenses that you incurred in relation to this claim.

Where CGT event C2 is triggered, section 118-37 of the ITAA 1997, may provide relief from income tax by disregarding the capital gain derived from an award of compensation or damages as the result of the taxpayer's personal injury.

According to the Commissioner of Taxation, in TR 95/35, section 118-37 of the ITAA 1997 will only apply to a compensation sum to amounts paid solely in respect of personal injury. If definitive amounts are awarded to the taxpayer, and those amounts are for non-personal injury, then they will not qualify for this exemption. Likewise, if there is a non-personal injury element to the lump sum, and it is paid in an undissected lump sum, with the taxpayer not being able to make a reasonable apportionment between the different heads of claim, then none of the payment will be viewed as being paid for personal injury, and section 118-37 of the ITAA 1997 will have no application.

You received an undissected lump sum as a result of you entering into the deed of release. We consider that the compensation amount you received is not exempt within the requirements of subsection 118-37(1) of the ITAA 1997. The detriment suffered by you was not a wrong or injury that you suffered under any of the conditions outlined in subsection 118-37(1) of the ITAA 1997.

As any capital gain you have made on the receipt of the settlement payment is not exempt, you must include the capital gain arising in relation to your settlement amount in your assessable income in the income year in which it occurs.

Note: As you are an individual who has owned the CGT asset for at least 12 months prior to CGT event C2 happening and CGT event C2 happened after 21 September 1999, you are able to apply the CGT 50% discount to any capital gain that you make in relation to the receipt of the $415,000 compensation payment.