Edited version of your written advice

Authorisation Number: 1013064604434

Date of advice: 5 August 2016

Ruling

Subject: Assessability of lump sum payment

Question 1

Is the lump sum payment you received to finalise your TPD claim assessable as ordinary income?

Answer

No.

Question 2

Is the lump sum payment you received to finalise your TPD claim included in assessable income under the capital gains provisions?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

You developed a medical condition and lodged a TPD claim with your Superannuation fund.

At that time you ceased employment and became eligible to receive a disability support pension from the Australian Government.

Your TPD claim was not accepted and the matter went to court.

The insurer of the super fund, yourself and the super fund were parties to the claim.

Your super fund and its insurer declined payment of the TPD benefit pursuant to the fund and the policy. The matter was settled out of court with no party admitting liability.

The deed of release states that your super funds insurer agreed to pay a settlement sum to you, in exchange for your undertakings in the deed.

The deed states that on payment of the settlement sum, your benefits under the policy are forever extinguished, and you are no longer a person insured under the policy.

The settlement was made as a lump sum and paid directly by the super funds insurer to the trust account of your legal representative.

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 6-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 118-37

Reasons for decision

Ordinary income

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.

In your case, you have not earned the lump sum payment as it does not directly relate to services performed. Rather the lump sum relates to personal circumstances that have arisen as a result of illness. The payment is also a one-off payment and thus does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from the expectation of compensation for your TPD claim, rather than from a relationship with personal services performed. Thus, the lump sum payment is not considered 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.

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 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 or on the ending of rights under an insurance policy. 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 then 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 or 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 section 118-37 of the ITAA 1997.

However, the application of paragraph 118-37(1)(a) of the ITAA 1997 in relation to other types of 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) 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.

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.

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 concessional treatment can be applied unless you are able to prove that the amount received was solely for personal injury or illness.

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

In your case, the insurer is offering a full and final settlement of any claims under the policy with an undissected 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 undissected lump sum payment is assessable as a capital gain and the exemption contained in section 118-37 of the ITAA 1997 can not apply.

Your payment cannot be said to be for a single defined payment for an injury or illness. No liability is admitted by your super fund or its insurer in making the lump sum payment to you. The lump sum is not dissected, that is it has no breakdown of amounts for illness, loss of income or injury. The lump sum payment you received is contingent on the agreement that you forgo any future right to make any claim against both the super fund and the insurer.

As was the case in 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 payment. Therefore the lump sum payment is assessable as a capital gain and the exemption contained in section 118-37 of the ITAA 1997 cannot apply.