Edited version of private advice

Authorisation Number: 1012646225258

Ruling

Subject: Lump sum payment

Question

Is the lump sum payment received under the Disability Income Insurance policy assessable as ordinary income?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

The arrangement that is the subject of the 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:

n the application for private ruling including the deed of release and

n Disability Income Insurance customer information brochure and policy document.

You took out a disability income insurance policy.

You submitted a claim for benefits as you suffered from a disability.

You received monthly benefits under the policy until 20xx.

You requested the insurance company for ongoing benefits. You were advised that you did not meet the terms and conditions for an entitlement to a benefit under the policy.

You commenced proceedings against the insurance company seeking re-instatement of monthly benefits from 20xx under the policy together with damages, interest and costs.

Without admission of liability, you and the insurance company agreed to resolve and wholly extinguish their respective rights and entitlements and purported rights and entitlements under the policy.

You agreed that the settlement sum is paid in full and final satisfaction and discharge of all claims under the policy.

A settlement sum was paid to your solicitor. The settlement sum was inclusive of interest and costs less any applicable tax required to be deducted by law (if any).

The solicitor deducted professional fees and other costs from the settlement sum and paid you the balance.

Relevant legislative provisions

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

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:

• are earned,

• are expected,

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

Payments of salary and wages are income according to ordinary concepts and are included in assessable income under section 6-5 of the ITAA 1997.

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 a disability income insurance 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 an income protection 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.

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 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income? As outlined in paragraph 4 of TD 93/3, a commutation of periodic payments to a lump sum 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 taxpayers 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 taxpayers 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 disability income insurance policy protects and provides income in the event of illness or disability. Under the policy you are entitled to up to 75% of your earned income if disability occurs. The benefits provide a regular income and are paid monthly. The policy document states that benefits are generally assessable income.

That is, the regular payments paid under your policy replace lost earnings (salary). The purpose of the payments is a substitute for the income which would otherwise have been earned.

Following your request to seek re-instatement of your monthly benefits, you were offered a lump sum payment in full settlement of the policy. As the benefits under the policy provide income when you are disabled, the lump sum was paid to substitute for loss of income which otherwise would have been earned. As your previous periodic income replacement payments were ordinary income, the lump sum payment also retains the character of being ordinary income.

Consequently, the lump sum payment is assessable under section 6-5 of the ITAA 1997.

Please note, that the full settlement amount is regarded as assessable income. However you are entitled to a deduction for the legal expenses incurred in relation to your settlement.