Edited version of your written advice

Authorisation Number: 1012932123438

Date of advice: 24 December 2015

Ruling

Subject: Assessable income - Income protection lump sum payment

Question 1

Is a lump sum paid to you to terminate an income protection insurance policy under which you receive a regular income stream assessable income?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You were injured in an accident.

You are currently receiving a regular income stream from an income protection policy. These payments are considered taxable income as they are replacing your lost salary.

You have declared these amounts on your annual tax return as taxable income.

Your insurer has offered to pay you a lump sum amount in final settlement of your claim.

You have received a proposed Deed of Release from your insurer to accept an amount in return for

(a) The Claimant surrendering all his remaining rights and entitlements to benefits including all income and other benefits under the Policy in respect of the Claim; and

(b) The Policy being cancelled with effect from the date of the Claimant's execution of this Deed.

The current policy proceeds, an amount per annum indexed to inflation and payable until you are 65 years of age.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

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

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include 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 under ordinary concepts (FC of T v. Inkster (1989) 20 ATR 1516; 89 ATC 5142; Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641; Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

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 a personal accident, income protection or disability insurance 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.

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.

It is well established that, in general, insurance moneys are received on revenue account where the purpose of the insurance was to fill the place of the revenue receipt which the event insured against has prevented from arising (Carapark Holdings Ltd v. Federal Commissioner of Taxation (1967) 115 CLR at 633).

The issue of whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability was considered by the Commissioner in Taxation Determination TD 93/3. As outlined in paragraph 4 of TD 93/3, such a commutation would result in the lump sum remaining assessable, as its effect is simply to pay in advance the future periodic 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 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 as consideration for 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.

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.

Primarily the settlement of a dispute involving an income protection policy would amount to the disposal of a right to seek compensation. However, underlying this is the forfeiture of your rights under the contract - predominately, this would involve the right to receive an income stream but there may be subsidiary benefits at issue.

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.

In your case, the income protection policy provides you with a regular income stream which we consider to be, ordinary income and are included in assessable income under section 6-5 of the ITAA 1997.

You may be offered a lump sum payment in full settlement of the policy. If this occurs, the future regular payments will be commuted to a lump sum. As the periodic payments are ordinary income, the lump sum payment also retains the character of being ordinary income.

It is acknowledged that in accepting the lump sum you will give up your rights in relation to the policy. However, it is considered that your case is similar to Sommer's case and the lump sum represents a redemption of the right to receive income and is also regarded as income in nature.

The fact that the income benefits under the policy will be made in one lump sum does not change the revenue character of the receipt as it will essentially be designed to compensate you in respect of your income claims, or as a payment in substitution of those claims.

Consequently, a lump sum finalisation payment which relieves the obligation to make future payments to you retains its character of ordinary income and is assessable under section 6-5 of the ITAA 1997 in the year that you receive it.