Edited version of your written advice

Authorisation Number: 1012763243132

Ruling

Subject: Compensation

Question

Is the lump sum payment that you received under the settlement assessable as ordinary income?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

You were employed as computer programmer.

In 19XX you were diagnosed with a serious illness.

You claimed payment of group salary continuance benefits pursuant to your employer's insurance policy, monthly benefits were subsequently paid.

In 20XX the insurer reduced the monthly payment, they recalculated the payment based on your average salary over the previous year where you became sick and not the salary which you were deriving at the time you ceased work.

You initiated legal proceedings in the County Court of an Australian state disputing the recalculated amount.

With admission of liability and in order to avoid the costs, expense and inconvenience of litigation, you and the insurer have agreed to pay you the sum of $X. In return you agree to release the insurer from any liability under the 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

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.

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.

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 are receiving regular payments under the policy and are considering accepting a lump sum payment in respect of your remaining entitlements.

You have commenced proceedings against the insurer essentially disputing the amount of assessable income that should have been paid to you under the policy. 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. Therefore, the lump sum payment you will receive 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

In entering into the settlement you have surrendered a right of making a claim against the insurer for the benefits under the insurance policy. This gives rise to CGT event C2. As with Purvis although the loss of income has arisen out of an injury or illness the payment from the insurer does not directly relate to compensation or damages but rather an entitlement to be paid under the insurance policy.

However as it has been also determined above that the payment you will receive is assessable as ordinary income or statutory income, the anti-overlap provisions in section 118-20 will operate to reduce the capital gain arising as a result of CGT event C2 by the amount of the income assessed to you under either sections 6-5 or 15-30.

The combined effect of sections 6-5, 15-30 and 118-20 is that the receipt will be assessed as ordinary income and the capital gain as a result of the CGT event will be reduced to nil.

Should we have erred in characterising the lump sum payment as ordinary or statutory income, the payment would nonetheless be assessable as a capital gain under section 102-5 and the exemption under paragraph 118-37(1)(b) would not apply.