Edited version of private advice

Authorisation Number: 1012653435715

Ruling

Subject: Income protection proceeds

Question

Is the payment that you received from your insurer assessable income?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You took out an income protection policy. The policy commenced mid 200X.

You lodged a claim towards the end of 20XX.

Your insurer did not want to pay the claim as they believed it was a pre-existing condition.

At the end of 20YY, you lodged a dispute with the Financial Services Ombudsman (FOS).

You were seeking a monthly benefit backdated to your claim date and a refund of the premiums paid.

The FOS ruled that your injury is classified as total disablement, and that you were entitled to a monthly benefit backdated.

The FOS ruled that your insurer must refund the premium payments.

The FOS ruled that your insurer must also pay interest on the amounts due to you.

In the letter of payment, your insurer asks for information to assist them with your ongoing claim.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Income Tax Assessment Act 1997 subsection 6-5(2).

Income Tax Assessment Act 1997 section 104-25.

Income Tax Assessment Act 1997 section 118-20.

Income Tax Assessment Act 1997 section 118-37.

Reasons for decision

Summary

The lump sum payment you received is assessable as ordinary income or statutory income.

Detailed reasoning

*All legislative references contained are to the Income Tax Assessment Act 1997.

Introduction

Generally, an amount received in relation to an insurance policy for income protection would be assessable either as:

• ordinary income under section 6-5 (whether received as regular payments or a lump sum)

• statutory income under section 15-30 (where a lump sum insurance payment is paid in lieu of regular, otherwise assessable payments and it is not itself ordinary income)

• a capital gain as CGT event C2 will also happen, but any resulting capital gain is disregarded to the extent that it is assessed under another provision (section 118-20).

Ordinary income

Periodic income protection payments

Subsection 6-5(2) 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, expected, 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 your assessable income.

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 included in your assessable income on the same principle as salary and wages.

Lump sum payments

Whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability as ordinary income 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 a redemption of those future weekly payments was also income.

This view was subsequently 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 a revenue account. The fact that the payment was received in one lump sum did not change its revenue character.

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.

Statutory income

Section 15-30 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 but was not assessable under section 6-5.

Capital gains

While a payment may be properly characterised as ordinary income, a capital gain may still be made and in answering whether a payment is included in your assessable income, it is appropriate to examine these provisions also.

However, it should be immediately noted the anti-overlap provisions contained in section 118-20 operate generally to reduce any capital gain by the amount of that income which has been otherwise assessed to you as ordinary income under section 6-5 or statutory income under section 15-30.

Part 3-1 contains the capital gains and capital loss provisions commonly referred to as CGT (capital gains tax). You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset.

Section 104-25 provides that CGT event C2 happens on the ending of the rights under an insurance policy. The lump sum amount you receive will be capital proceeds for this CGT event and a capital gain will usually arise.

The net capital gain you make is then included in your assessable income under section 102-5 (after being reduced by the aforementioned overlap provisions as required).

CGT Exemption

Paragraph 118-37(1) (b) allows a capital gain to be disregarded if it is compensation or damages you receive for any wrong, injury or illness you suffer personally.

This provision would have clear and direct application in relation to an insurance policy against a specific injury or illness. For example, trauma insurance that pays a lump sum if the person loses a limb or suffers a heart attack. Such a payment would be disregarded for CGT purposes under 118-37(1)(b).

However, the application of 118-37(1)(b) in relation to other types of personal insurance and in circumstances involving the buying out of the policy or the settling of disputes in relation to a policy may be more problematic.

In the case of Purvis v. FC of T [2013] AATA 58, the Administrative Appeal Tribunal considered the tax consequences of a Qantas pilot receiving a lump sum insurance payment for the loss of licence. Although the loss of licence came about as a result of illness or injury, the Tribunal found that the payment did not relate directly to compensation or damages within 118-37(1)(b). The amount was calculated without regard to the nature of the personal injury suffered, save that the personal injury had to result in the loss of licence.

In cases where an insurer is seeking to buy out a policy, the payment is intended to compensate the policy holder for the loss of entitlements under the policy, not necessarily to compensate the person for their injury or illness.

Underlying asset and Taxation Ruling TR95/35

Where compensation is intended to remedy damage to an asset, taxing of that compensation may prevent the remedy occurring. For example, if you incur $1,000 damage to your car and receive $1,000 in compensation, paying tax on that amount would frustrate the purpose of the compensation. For this reason, it is sometimes necessary to identify the damaged underlying asset that the compensation was intended to remedy, and to consider the capital gains tax consequences of the compensation in relation to that asset.

Taxing the compensation for the giving up of an income stream does not create this issue, as the income stream would have itself been taxable. Taxing compensation intended to cover medical benefits, however, may frustrate the purpose of the compensation. In these circumstances it may be appropriate to concede that compensation for the payment of medical costs are sufficiently related to personal illness or injury to be exempt from capital gains under paragraph 118-37(1)(b).

Taxation Ruling TR 95/35 deals with the issue of compensation and outlines when it may be relevant to consider the compensation in the context of an underlying asset.

If the compensation is received in relation to multiple heads of claim, TR 95/35 allows a reasonable apportionment of that payment. For example, if a payment is intended to replace both an income stream and other potential benefit entitlements, the payment may be apportioned between the two heads of claim on a reasonable basis.

However, if the payment is truly an un-dissected lump sum - that is, no reasonable apportionment can be made between the multiple heads of claim - no concessional treatment can be applied unless you are able to prove that the amount received was solely for personal injury.

This approach was confirmed in Dibb v Commissioner of Taxation [2004] FCAFC 126 which found that no part of a genuinely un-dissected lump sum could be said to be paid in relation to personal injury. The exemption in paragraph 118-37(1)(b) cannot apply if the compensation amount is received as a lump sum (and that lump sum is truly un-dissected) but there were rights to income type payments as well as rights relating to personal injury that are extinguished in the settlement.

Recoupment

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss or outgoing is an assessable recoupment if:

• you received the amount by way of insurance or indemnity, and

• you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it in an earlier income year, under any provision of this Act.

Interest

Subsection 6-5(2) of the ITAA 1997, provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Taxation Ruling TR 95/35 provides the Commissioners view on the assessability of interest payments that are received as a result of a compensation payment. Paragraph 26 states that Interest awarded as part of a compensation amount is assessable income of the taxpayer under the general income provisions.

Application to your circumstances

Ordinary income

In your case, you hold an income protection policy designed to protect and provide income in the event of illness or disability. You lodged a dispute with the FOS which resulted in your insurer paying you lump sum made up of a monthly entitlement backdated, premium refunds and interest.

Your situation is similar to Sommer's case in that you received an amount in settlement of income claims against your income protection insurance policy. In Sommer's case it was determined that the payment was revenue despite being paid in a lump sum.

The fact that the FOS ruled that your injury was a total disablement does not change the character of the payment you received. Therefore, the lump sum payment you received is assessable as ordinary income under section 6-5.

Statutory income

Should the Commissioner have erred in characterising the lump sum payment as ordinary income, the payment would be included in your assessable income under section 15-30 as statutory income. Noting that the periodic receipt of income protection payments is considered ordinary income, the payment is an indemnification of the loss that income; and as such, will be included in your assessable income.

Capital gains

Your insurer has agreed to pay you a lump sum payment in settlement of your claim. However, your insurer is not proposing the full and final settlement of any claims under your policy. They have included details on what you need to do to assist with the ongoing assessment of your claim. Therefore, there is no ending of your rights under the insurance policy and no CGT event.

The combined effect of sections 6-5 and 15-30 is that the receipt will be assessed as ordinary income.

Recoupment

In your case you received a recoupment of the income protection premiums paid. This recoupment will be assessable income.

Interest

You have received a lump sum payment that includes an amount of interest in relation to the delays in processing your payment. This interest component of the payment has been dissected from the other elements of the compensation payment and as such can be clearly identified.

Therefore, the interest received from your payment is considered to be ordinary income and as such assessable under section 6-5 of the ITAA 1997.