Edited version of your written advice

Authorisation Number: 1013007750715

Date of advice: 17 May 2016

Ruling

Subject: Compensation payment

Question 1

Is the compensation payment for future wages regarded as ordinary assessable income?

Answer

Yes.

Question 2

Is the lump sum compensation payment for loss of future wages regarded as an employment termination payment (ETP)?

Answer

No.

Question 3

Will any capital gain arising from the compensation amount be disregarded?

Answer

No.

Question 4

Will any capital gain arising from the compensation amount be reduced to nil under section 118-20 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commenced on

1 July 20XX

Relevant facts

You were an employee.

You were at work when you suffered an injury.

You completed a claim for compensation under the relevant legislation and your employer accepted liability for the claim.

Your employer paid you weekly compensation.

You were made redundant.

Subsequently you and the employer agreed to settle your claim and any claim for common law damages or claims of a similar nature as a result of the injury by way of a deed of release and discharge.

You received a lump sum in settlement. The Deed of Release and Discharge states that the amount is for compensation and/or damages for the injury. A component of the lump sum was for future wages.

You received your lump sum in the 20XX-YY financial year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10.

Income Tax Assessment Act 1997 Paragraph 118-37(1)(a)

Income Tax Assessment Act 1997 Section 82-130

Income Tax Assessment Act 1997 Section 82-135.

Detailed reasoning

Assessable income

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.

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).

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, you were receiving weekly compensation payments. The regular payments received 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 settlement payment. A component of your settlement payment included an amount for future wages. 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.

Please note that the future wage component is not regarded as a payment for the loss of earning capacity.

Statutory income

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.

The relevant provisions in your circumstances are employment termination payment provisions and the capital gains tax provisions.

Employment termination payment

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's employment; and

(b) it is received no later than 12 months after the termination; and

(c) it is not a payment mentioned in section 82-135.

A life benefit termination payment is an employment termination payment (ETP) to which subparagraph 82-130(1)(a)(i) applies.

Section 82-135 of the ITAA 1997 provides that certain payments are not ETPs, including:

• payments for unused annual leave or unused long service leave

• the tax-free part of a genuine redundancy payment or an early retirement scheme payment

• reasonable capital payments for personal injury.

To determine if a payment constitutes a life benefit termination payment, all the conditions in section 82-130 of the ITAA 1997 need to be satisfied.

Failure to satisfy any of the conditions will result in the payment not being considered an ETP.

In consequence of employment termination:

The first criteria states that the payment is received by the person in consequence of the termination of their employment.

The phrase in consequence of is not defined in the ITAA 1997. However, the words have been interpreted by the courts in several cases. The Commissioner has also issued Taxation Ruling TR 2003/13 which discusses the meaning of the phrase.

The Full High Court of Australia considered the expression in consequence of the termination of any employment in Reseck v. Federal Commissioner of Taxation (1975) 133 CLR 45; 75 ATC 4213; (1975) 5 ATR 538 (Reseck). The relevant issue in that case was whether amounts paid to a taxpayer by his employer at the end of two periods of employment, to which the taxpayer was entitled under an agreement between the employer and the taxpayers union, were an allowance paid in a lump sum in consequence of retirement from, or the termination of, any office or employment. Justice Gibbs concluded that the amounts were made in consequence of the termination of the taxpayer's employment. His Honour said that:

Within the ordinary meaning of the words, a sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment. In the present case the allowance was paid in consequence of a number of circumstances, including the fact that the taxpayer's service had been satisfactory and that the industrial agreements provided for the payment, but it was none the less paid in consequence of the termination of the taxpayer's employment.

Justice Jacobs also concluded that the amounts constituted an allowance that was paid in consequence of the termination of the taxpayer's employment. His Honour said:

It was submitted that the words in consequence of import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a following on.

The Commissioner in TR 2003/13 considered the phrase in consequence of as interpreted by the Courts. Paragraph 5 of TR 2003/13 states:

…the Commissioner considers that a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

The question of whether a payment is made in consequence of the termination of employment is determined by the relevant facts and circumstances of each case.

In your case it is considered that the payment made to you followed on from the termination of your employment due to your injury.

The 12 month rule:

Paragraph 82-130(1)(b) of the ITAA 1997 requires that a payment must be received within 12 months of the termination of employment (or such greater period as the Commissioner determines) to qualify as an ETP.

The facts show that your employment ceased in April 2015 and the payment was made in the 20XX-20YY income year. As the payment was made within 12 months of the termination of your employment, paragraph 82-130(1)(b) of the ITAA 1997 is satisfied.

Section 82-135 of the ITAA 1997

The last relevant condition for consideration is whether the payment received by you is one of payments excluded from being an ETP under section 82 135 of the ITAA 1997.

In your case it is considered that the facts, particularly the Deed, support the payment received by you is the type of payment found in paragraph 82-135(i) of the ITAA 1997 which refers to a capital payment for or in respect of, personal injury to you so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on your capacity to derive income from personal exertion.

In view of the above the payment you received is excluded from being treated as an ETP.

Capital gains

Part 3-1 of the ITAA 1997 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.

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 will receive will be capital proceeds for this CGT event and a capital gain will usually arise.

The net capital gain you make is included in your assessable income under section 102-5 of the ITAA 1997.

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.

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 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 subsection 118-37(1) 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 as such.

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.

Taxing the compensation for the giving up of an income stream does not create this issue, as the income stream would have itself been taxable. Taxing compensation intended to cover medical benefits, however, may frustrate the purpose of the compensation. In these circumstances it may be appropriate to take a concessional approach and concede that compensation for the payment of medical costs are sufficiently related to the injury to be exempt from capital gains under paragraph 118-37(1)(a) of the ITAA 1997.

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 compensation claim would amount to the disposal of a right to seek compensation. However, underlying this is the forfeiture of your rights under the SRCA - in some cases, this would predominantly involve forfeiting the right to receive an income stream; but in some cases, there may also 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. 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 subsection 118-37(1) 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

Acceptance of the lump sum is considered to be a payment for the ending of your rights under the relevant legislation. This gives rise to CGT event C2. The future wage component of your payment cannot be said to be for a single defined payment for an injury or wrong you suffer in your occupation.

The future wage component is not a personal injury payment. Therefore this component of your lump sum settlement payment is assessable as a capital gain and the exemption contained in paragraph 118-37(1)(a) of the ITAA 1997 cannot apply.

Please note, that as your future wage component payment 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.