Edited version of your written advice

Authorisation Number: 1013000977789

Date of advice: 20 April 2016

Ruling

Subject: Compensation payment

Question 1

Is the lump sum settlement payment regarded as ordinary assessable income?

Answer

No.

Question 2

Is the lump sum settlement payment disregarded under the capital gains tax provisions?

Answer

No.

Question 3

Is the lump sum settlement payment assessable under the capital gains tax provisions?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commenced on

1 July 20XX

Relevant facts

You suffered an injury in the course of your employment.

You submitted a claim for compensation for the injury pursuant to the Workers Rehabilitation and Compensation Act (WRCA).

You sought compensation for future loss of earning capacity, medication, GP visits, past medical expenses, permanent impairment and legal costs.

The employer disputed liability for the claim on the basis that you did not suffer an injury and the employment was not the real, proximate or effective cause of the injury or disease. You disputed the employer's notice in relation to this.

In 20XX-YY financial year the claim was resolved with your employer and as outlined in the Deed of Agreement, you received a sum as a capital payment for any loss of earning capacity, medical and like expenses, permanent impairment assessment arising from the injury and the claim and any and all entitlements to compensation pursuant to the WRCA. The agreed payment is an all-inclusive amount of any entitlements owed to you and includes legal costs and disbursements, any entitlement to interest and repayment to statutory authorities including but not limited to Centrelink and Medicare Australia.

The parties agree that the payment is made without admission of liability by the employer in relation to the dispute and proceedings or that you are entitled to any compensation with respect to the injury and the claim.

You acknowledge and agree that if you make a claim for compensation in respect of the injury and/or seek further to pursue any claim for compensation against the employer you shall be liable to repay the employer the agreed payment.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10.

Income Tax Assessment Act 1997 Section 118-37

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 the ordinary income derived directly or indirectly from all sources, whether in or out of Australia, 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.

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).

If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. Compensation for loss of earning capacity is compensation for the loss of a capital asset (that is, the capacity to earn income) and is capital in nature.

Medical expenses are private expenditure. Compensation for medical expenses does not relate to loss of income and does not give rise to ordinary assessable income.

In your case you have received a lump sum payment in full and final settlement of your compensation claim. The payment included amounts for loss of earning capacity, medical expenses and other entitlements. No component of the lump sum payment was received to compensate for loss of income.

Your lump sum settlement received does not relate to personal services, property, or the carrying on of a business. The payment is a one-off payment and thus does not have an element of recurrence or regularity. Although it can be said that the lump sum payment is to be expected, and perhaps relied upon, this expectation does not arise from the performance of personal services. In your circumstances, the lump sum payment is not ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income, and are also included in assessable income.

Amounts received as a lump sum are generally capital in nature and are potentially taxable as statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

Capital gains

Part 3-1 of the ITAA 1997 contains the capital gains and losses 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.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation, that is, the right to take legal action. The lump sum amount you received is capital proceeds for this CGT event and a capital gain will usually arise. The net capital gain you make is generally included in your assessable income under section 102-5 unless a CGT exemption applies.

CGT exemption

Paragraph 118-37(1)(a) of the ITAA 1997 allows a capital gain to be disregarded if it is compensation or damages you receive for any wrong or injury you suffer in your occupation.

Paragraph 118-37(1)(b) of the ITA 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.

These provisions 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 section 118-37 of the ITAA 1997. However, the application of section 118-37 of the ITAA 1997 in relation to settling a compensation claim may be more problematic.

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.

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.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts outlines when it may be relevant to consider the compensation in the context of an underlying asset.

Primarily the settlement of a dispute involving a workers' compensation claim would amount to the disposal of a right to seek compensation. However, underlying this is the forfeiture of your rights under the WRCA.

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 exemption 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) of the ITAA 1997 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.

Application to your circumstances

Your lump sum settlement includes capital benefits such as loss of earning capacity as well as payment for medical expenses. It is therefore accepted that the payment is a not an income type payment and that the lump sum payment is not assessable under section 6-5 of the ITAA 1997.

Acceptance of the lump sum is considered to be a payment for the ending of your rights under the WRCA. This gives rise to CGT event C2. Your payment cannot be said to be for a single defined payment for an injury. There is no information to show that the payment was calculated based on your personal injury or illness. In fact the employer is not agreeing that there was a work place injury.

As was the case in Sommer's case and Purvis' case, although your compensation may have been triggered by a personal injury or illness, the actual lump sum payment is not a personal injury or illness payment. The payment covers a loss of various rights and entitlements. That is, your payment is intended to compensate you for the loss of entitlements under the WRCA, rather than to compensate you for your injury or illness as such.

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. Consequently, it is considered that the capital gain cannot be disregarded under the above provision.

As the exemption contained in section 118-37 of the ITAA 1997 cannot apply to your lump sum payment, the capital gain is assessable.

It should be noted, that the associated legal costs form part of the cost base for capital gains purposes.