Edited version of your private ruling

Authorisation Number: 1012446950409

Ruling

Subject: Assessable income - Lump sum settlement

Question 1

Is an undissected lump sum settlement amount paid by a franchisee for a termination/breach of contract assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Is the lump sum settlement amount assessable as a capital gain under section 102-5 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods

Year ending 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

You are a franchisor.

A Franchisee entered into a Franchise Agreement for a binding term, and for that term had specific duties and weekly fees payable.

Prior to the expiration of that term the Franchisee breached the contract including terminating the contract.

You asserted your rights to an appropriate remedy and pursued the franchisee for adequate compensation for several heads of claim including damages, losses under the contract and damage to reputation.

You resolved the dispute out of court through negotiation.

The parties entered into the settlement arrangement.

The amount of the lump sum settlement payment was undissected.

The 'Deed of Surrender and Release' ('the Settlement Deed') provided that the payment was in consideration of the Franchisor entering into the Deed and the Franchisor releases the Franchisee from any and all obligations, actions, suits, claims and demands arising as a result of the Franchise Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-25

Reasons for decision

Question 1

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

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.

In this instance, the settlement offer of a lump sum payment has been made to compensation for several heads of claim including damages, losses under the contract and damage to reputation. 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 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 amount is treated as a non-assessable receipt.

As the proposed lump sum payment to the taxpayer would comprise compensation for a mixture of income and capital items and the payment cannot be dissected into its constituent parts, the whole amount of compensation is considered to be of a capital nature.

Therefore, the lump sum amount is not assessable income under section 6-5 of the ITAA 1997.

Question 2

A CGT asset includes a legal or equitable right that is not property: paragraph 108-5(1)(b) of the ITAA 1997.

The CGT asset in this case is the right to seek compensation.

CGT event C2 happens when an intangible CGT asset is surrendered, cancelled or forfeited or similarly ends: section 104-25 of the ITAA 1997. A capital gain will arise if the capital proceeds from the ending are more than the right's cost base: subsection 104-25(3) of the ITAA 1997.

Taxation Ruling TR 95/35 deals with the capital gains treatment of compensation receipts. The ruling advocates a 'look-through' approach, which identifies the most relevant asset to which the compensation amount is most directly related. Paragraph 11 of TR 95/35 states that if an amount is not received in respect of an underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

As the amount you received is not in respect of any underlying asset, the whole of the settlement amount is treated as capital proceeds from a CGT event (CGT event C2) happening to your right to seek compensation.

In your case, the right to seek compensation was acquired when the contract was breached.

The cost base of the right to seek compensation is determined in accordance with the provisions of Division 110 of the ITAA 1997. Legal fees and charges connected with the proceedings and incurred during the course of proceedings may be included in the cost base of the asset.

The right is disposed of when you agree to a release, discharge, satisfaction or surrender of your right to seek compensation. In your case, this is when the parties enter into the settlement arrangement.

Accordingly, the lump sum settlement amount is assessable as a capital gain in the relevant financial year.