Edited version of your written advice

Authorisation Number: 1012826921771

Date of advice: 19 June 2015

Ruling

Subject: Lump sum payment

Question

Will the lump sum payment from an early settlement of your income protection policy be assessable income?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commenced on

1 July 2014

Relevant facts

You have been receiving monthly payments from an income protection policy for a number of years.

Entity A may payout a lump sum as early settlement of the policy/claim.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 Section 6-10

Reasons for decision

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

• ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) (whether received as regular payments or a lump sum)

• statutory income under section 15-30 of the ITAA 1997 (where a lump sum insurance payment is paid in lieu of regular, otherwise assessable payments and it is not itself ordinary income); and/or

• a capital gain as capital gains tax (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 of the ITAA 1997).

Ordinary income and lump sum payment

Subsection 6-5(2) of the 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 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 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 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 is providing income. The regular payments received in relation to this policy replace lost earnings (salary). The purpose of the payments is a substitute for the income which would otherwise have been earned.

You are being offered a lump sum payment in full settlement of the policy. That is, your future regular payments will be commuted to a lump sum. The lump sum will be 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.

Statutory income

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.

As you payment is assessable under section 6-5 of the ITAA 1997, section 15-30 of the ITAA 1997 does not apply in your circumstances.

Capital gains

While a payment may be characterised as ordinary income, a capital gain may still be made. However, an anti-overlap provision prevents income being assessed as both ordinary or statutory income and a capital gain, the latter being reduced to the extent it is assessed by the former (see section 118-20 of the ITAA 1997).

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

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 will receive is a final settlement and is not in respect of an underlying asset, the whole of the settlement amount is treated as capital proceeds from your right to seek compensation.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation. The lump sum amount received would generally 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 of the ITAA 1997 (after being reduced by the aforementioned overlap provisions as required).

CGT Exemption

Paragraph 118-37(1)(b) of the ITAA 1997 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 paragraph 118-37(1)(b) of the ITAA 1997.

However, the application of paragraph 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 not be relevant.

In the case of Purvis v. FC of T [2013] AATA 58 (Purvis' case), the Administrative Appeal Tribunal considered the tax consequences of a 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 paragraph 118-37(1)(b) of the ITAA 1997. 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 a dispute between the insurer and the insured is settled by way of the former making a lump sum payment to the latter; it would presumably be the case that the payment is intended to compensate the policy holder for the loss of entitlements under the policy, rather than to compensate the person for their injury or illness as such.

Your insurer has offered to pay a full and final settlement of any claims under your policy with a lump sum payment. Acceptance of the lump sum is considered to be a payment for the ending of your rights under the insurance policy. This gives rise to CGT event C2. Therefore the lump sum payment is assessable as a capital gain.

In your case your lump sum payment is not in relation to a single defined payment for a specific illness rather it is a lump sum for your future monthly payments.

As was the case in Sommer's case and Purvis' case, although your payments may have been triggered by a personal injury, the actual payment was not a personal injury payment. The payment covered a loss of rights and entitlements, including a loss of income under the policy.

Therefore, in relation to whether the settlement payment would be disregarded under paragraph 118-37(1)(b) of the ITAA 1997, it is considered that the payment cannot be considered to be solely a payment of compensation for the illness/injury that entitled you to make a claim under the policy. Consequently, it is considered that the capital gain cannot be disregarded under the above provision.

Please note, that as your settlement sum is assessable under section 6-5 of the ITAA 1997, any capital gain is reduced to nil under section 118-20 of the ITAA 1997.