Edited version of your written advice

Authorisation Number: 1012700794627

Ruling

Subject: Lump sum payments

Question

Are the lump sum payments received under the income protection policy assessable as ordinary income in the year of receipt?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2014

Year ended 30 June 2015

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:

• the application for private ruling including

• deed of release.

You have been unable to work for some years following a work place injury.

You have been receiving a monthly benefit from your income protection policy. The benefit was subject to tax and you have been declaring the benefits as assessable income.

You did not receive reimbursement of your medical expenses or other benefits under the policy.

The insurance company approached you to settle the policy and you agreed on a lump sum to be paid in two payments. The payments were made in two separate financial years.

The settlement sum is in full and final satisfaction of your rights for payments of benefits under the policy.

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, 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 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 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 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, 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 was subsequently 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 income protection policy protects and provides income in the event of illness or disability. The regular payments received in relation to this policy replaced lost earnings (salary). The purpose of the payments was a substitute for the income which would otherwise have been earned.

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. The lump sum was paid to substitute for loss of income which otherwise would have been earned. As the periodic income replacement payments are 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.

We acknowledge your specific circumstances and that the tax rate is higher when the lump sums are taxed in the year of receipt, however the legislation does not provide any reduced tax rate or concession in these circumstances.

Please note, where an insurance amount is not regarded as ordinary income under section 6-5 of the ITAA 1997, it is generally assessable under section 15-30 of the ITAA 1997. Section 15-30 operates to include in 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 as assessable income but was not assessable under section 6-5.