Edited version of your written advice

Authorisation Number: 1051176598752

Date of advice: 22 December 2016

Ruling

Subject: Compensation

Question

Is any part of the compensation payment disregarded under the capital gains tax (CGT) provisions?

Answer

No.

This ruling applies for the following period

Year ending 30 June 201X

The scheme commenced on

1 July 201X

Relevant facts and circumstances

You were the land owners.

You acquired the property several years ago.

You resided on the land and conducted business activities on the land.

The property is located close to an industrial site.

The noises and fumes from the industrial site caused impairment to your right to quiet enjoyment of the property. You have suffered sleep loss and ongoing stress and anxiety.

A few years ago you were diagnosed with an illness.

A number of animals on the property have died as a result of illnesses.

The industrial site eroded the market value of the property.

Recently you attempted to sell the property in order to mitigate your losses. During the sale process you were advised that the property's value was less than purchase price.

You commenced legal action against entity A to remedy your economic losses and to compensate you.

In a letter to entity A, you requested entity A to purchase the property for a given amount.

You reached an out of court settlement with entity A. Under the agreement you received a lump sum payment.

In acceptance of the offer, you agreed to release and discharge entity A from all actions, suits, demands, causes of action, costs and expenses in relation to its operation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

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

Reasons for decision

Ordinary 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 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, 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.

In Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

The compensation payment received was not earned by you as it does not relate directly to services performed, property income or business activity. 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 nuisances caused by entity A.

Considering the full circumstances, the lump sum payment is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Statutory income

Amounts that are not ordinary income, but are included in your assessable income by another provision are called statutory income (section 6-10 of the ITAA 1997).

The provisions dealing with statutory income are listed in section 10-5 of the ITAA 1997. Included in this list is capital gains, section 102-5 of the ITAA 1997.

Capital gains tax provisions

Your assessable income includes your net capital gain for the income year (section 102-5 of the ITAA 1997). Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens.

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the capital gains tax implications for compensation receipts. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

● disposal of the underlying asset,

● compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and

● disposal of the right to seek compensation.

The transaction which generated your compensation receipt is the actions of entity A. After considering your full circumstances, it is considered that the relevant CGT asset in your case is the right to seek compensation. The payment received was in full settlement of all claims made.

Your right to seek compensation is an intangible CGT asset and your ownership of that asset ended when you accepted the compensation sum. At that time CGT event C2 happened. CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). In your case, the compensation lump sum payment represents capital proceeds for your CGT C2 event. The cost base will include your legal fees incurred.

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:

(i) any wrong or injury you suffer in your occupation; or

(ii) any wrong, injury or illness you or your relative suffers 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 against entity A 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)(a) 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 similar to yours, where a dispute is settled by way of an entity making a lump sum payment to a land owner, it would presumably be the case that the payment is intended to compensate the owner for the loss of entitlements and loss of enjoyment, rather than to compensate the person for their injury or illness or wrong suffered as such.

The settlement of a dispute between you and entity A amounts to the disposal of a right to seek compensation.

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, illness or wrong suffered.

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)(a) 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 compensation payment is not regarded as an income replacement and includes capital components for the continuing nuisances and loss of value to the property. It is therefore accepted that the payment is an un-dissected settlement amount and that the lump sum payment is not assessable under section 6-5 of the ITAA 1997.

Your payment cannot be said to be for a single defined payment for an injury, illness or wrong. The settlement agreement does not refer to any amount paid for medical expenses, stress, anxiety or other physical illness, injury or wrong.

As was the case in Purvis' case, although your compensation may have been triggered by a wrong, the actual lump sum payment is not a payment for a wrong, injury or illness you suffered. The payment covers a loss of various rights and entitlements. Therefore the lump sum 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 you acquired the right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to the capital gain.