Edited version of your written advice

Authorisation Number: 1051187539023

Date of advice: 6 February 2017

Ruling

Subject: Tax treatment of insurance proceeds

Question 1

Can the insurance proceeds be classified as 'mutual' receipts, such that xx% of the insurance proceeds are treated as non-assessable non-exempt income?

Answer

Yes

Question 2

Can the insurance proceeds be apportioned over the period covered by the insurance policy such that the insurance proceeds are assessable in the following income year on a pro-rata daily basis (to the extent that they are not treated as non-assessable non-exempt income):

31 March 2015;

31 March 2016; and

31 March 2017?

Answer

No

This ruling applies for the following periods

01 April 2014 to 31 March 2015

01 April 2015 to 31 March 2016

01 April 2016 to 31 March 2017

The scheme commences on

1 April 20WW

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

1. The Entity is a not for profit company.

2. The Entity operates a club.

3. The Entity is prohibited from making income or capital distributions to its members.

4. The Entity is not income tax exempt.

5. XX% of the Entity's receipts are treated as mutual receipts.

6. The Entity's premises were destroyed in a fire.

7. As a consequence of the fire, the Entity has been unable to trade from the date of the fire to the present point in time.

8. The Entity was the owner of insurance policies at the time of the fire including a 'business interruption' otherwise known as a 'consequential loss' insurance policy.

9. The Entity claimed a tax deduction for the business interruption insurance premiums in line with the mutuality percentage of the Entity; this means that YY% of the premiums were claimed as a tax deduction.

10. The business interruption policy was held for the purpose of covering the Entity for lost revenue during a period of inactivity, in order to allow the club to pay its ongoing expenses.

11. The insurance proceeds were calculated by the insurer (Insurer) to replace income for a period of approximately 18 months, from 20XX to 20YY.

12. The Entity received a number of payments from the insurer under the business interruption policy (“the insurance proceeds”):

13. Proceeds totalling $aa were received in the year ending 20XX and

14. Further insurance proceeds totalling approximately $bb were received in the year ending 20YY.

15. The Entity's clubhouse has not yet been rebuilt and is uninhabitable.

16. The Entity has been unable to recommence trading.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5 and

Income Tax Assessment Act 1997 Section 6-10.

Reasons for decision

Question 1

Summary

The business interruption insurance payment is not mutual income in and of itself. However, as the business interruption insurance is a compensation for the loss of the Entity's business proceeds it takes on the character of the business' proceeds. The Entity's business proceeds were both considered to be mutual receipts and ordinary income and as such this is how the insurance payments should be classified and apportioned appropriately.

Detailed reasoning

Ordinary income

Business interruption insurance otherwise known as consequential loss insurance is a type of insurance which covers the insured for the amount of loss resulting from interruption or interference due to the premises of the business being physically lost. The calculation of the amount of loss varies depending on the insurance policy.

Business interruption insurance in this instance was paid to replace the Entity's business proceeds during the period that the business is interrupted, or interfered with, due to the premises being burnt down.

Mutuality

Whether a receipt is income depends upon its quality in the hands of the recipient.

The term income is not defined in the Income Tax Assessment Act 1936 (ITAA 1936) or ITAA 1997. In The Bohemians Club v The Acting Federal Commissioner of Taxation [1918] 24 CLR 334, Griffith CJ stated at 337-338:

A man is not the source of his own income, though in another sense his exertions may be so described. A man's income consists of moneys derived from sources outside himself. Contributions made by a person for expenditure in his business or otherwise for his own benefit cannot be regarded as his income unless the Legislature expressly so declares.

The exposition by Griffith CJ has formed the basis of the principle of mutuality as it applies to Australia. As such, a receipt by a taxpayer will not have the quality of ordinary income if the mutuality principle applies to it.

The essence of the mutuality principle is that you cannot derive any gain, and therefore income, from dealings with yourself. The mutuality principle provides that where a number of people associate for a common purpose and contribute to a common fund in which they are all interested, any surplus of those contributions remaining after the fund has been applied to the common purpose that is then distributed to the contributors, is a return of funds and not income or profit.

The mutuality principle was described succinctly by McTiernan J in Revesby Credit Union Cooperative Ltd v Federal Commissioner of Taxation (1965) 112 CLR 564 (Revesby Credit Union) at 574-575:

The principle of mutuality seems to me to be settled. Where a number of people contribute to a fund created and controlled by them for a common purpose any surplus paid to the contributors after the use of the fund for the common purpose is not income but is to be regarded as a mere repayment of the contributor's own money…Incorporation of the fund is not relevant…What is required is that the fund must have been created for the common purpose and owned or controlled wholly by the contributors. If it is owned or controlled by anyone else the principle cannot apply…Furthermore any contributions to the fund derived from sources other than the contributors' payments, such as interest from the investment of part of the fund, or income from a business activity conducted by the members, cannot be taken into account in computing the surplus…Also the cases establish that the principle cannot apply unless at any given point in time the contributors to the fund are identical with the beneficiaries of the distribution of the surplus.

The decision therefore rests on whether or not the compensation payment under the business interruption policy paid by the Insurer counts as one made by a third party or one from dealings with themselves.

The Insurer is a third party and as such the compensation payment would not be mutual in and of itself. The income from the insurer would not be considered a mutual receipt as it is not contributed by members to the common fund.

Compensation payment characteristics

Since the compensation payment is not considered mutual income the next question is 'whether XX% of the receipts should be treated as mutual receipts and YY% treated as ordinary income as the compensation payments are made to replace the Entity's business proceeds?'

It is stated in ATO Interpretative Decision ATO ID 2002/175 Assessability of income protection policy payments to financially support the taxpayer (ATO ID 2002/175) that:

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).

This is added to in ATO Interpretative Decision ATO ID 2011/82 Assessable income: recoupments - insurance proceeds for destruction of capital works (ATO ID 2011/82) which states that:

Ordinarily, an amount paid to compensate for loss acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82; ATO ID 2002/175).

In Taxation Determination TD 93/3 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income? (TD 93/3) it was further noted amounts paid for compensation acquire the character of that which is substitutes as

the weekly payments are assessable income because they are paid as compensation for loss of income or salary, or because of their regular receipt and their nature as a supplement to income, etc (FC of T v. Inkster 89 ATC 5142; 20 ATR 1516). We consider that a lump sum payment, which is a partial commutation of weekly payments, does not change its character of compensation for loss of income. Effectively, the payment is an advance of future weekly payments. Consequently, it continues to be assessable under subsection 25(1).

When considering what a compensation receipt would be classified as, even when determining if a receipt is capital or income depends on why it was paid to the taxpayer and the character of the receipt to the taxpayer. This was further seen in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) which states at paragraph 188:

188. Whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt and the reasons why it was paid to the taxpayer ( FC of T v. Slaven 84 ATC 4077; (1984) 15 ATR 242). In that case, the Federal Court was required to consider the nature of an amount of compensation received by the taxpayer following a motor vehicle accident. The Court (Bowen CJ, Lockhart and Sheppard JJ), in concluding that the amount was paid as compensation for loss or impairment of the taxpayer's earning capacity, stated (84 ATC at 4085; 15 ATR at 252):

'It is the character of the receipt in the hands of the taxpayer as recipient that must be determined'.

It is consistently seen in these ATO views that the correct treatment of compensation receipts is determined by the receipts the payments are replacing. If the payments are replacing taxable income the correct treatment of the payments is that they are taxable, if the payments are replacing capital then they will treated as such and if the payments are replacing non-taxable receipts then they are non-taxable. In the case of mixed payments TR 95/35 sheds some light on their treatment, as it states in regards to a mixed payment of capital and income receipts at paragraph 196 that:

[the] cases do not preclude a proportionate approach to identifying and allocating amounts of compensation to the various heads of claim if the taxpayer receives a single undissected lump sum in satisfaction of those claims.

As the compensation payment takes on the character of that which it is substituted. It is then required to determine what the payment is substituting. In determining this, an entity's previous treatment of receipts and its tax deductions help give an indication on the correct treatment of the compensation payment.

The Entity has been claiming XX% of its receipts as mutual receipts and YY% as ordinary income for the previous three income tax years.

The Entity has also reduced all of its insurance tax deductions in line with the Entity's mutuality percentage. That is, the Entity claimed YY% of the cost of the insurance premiums as a tax deduction. This treatment of the insurance premiums is in line with the idea that the business interruption insurance payout was envisaged to be proportioned in line with the Entity's mutuality percentage.

This apportionment also means that the business interruption compensation payment occurred as a direct result from the member's contributions to the insurance premiums. Further, as the compensation payments have taken on the character of the substituted amount, the funds would be contributing to the common fund for a common purpose.

Conclusion

As the business interruption insurance is a compensation for the loss of the Entity's business proceeds it takes on the character of the business' proceeds. The Entity's business proceeds were both mutual receipts and ordinary income and as such this is how the insurance payments should be classified and apportioned appropriately.

Question 2

Can the insurance proceeds be apportioned over the period covered by the insurance policy such that the insurance proceeds are assessable in the following income year on a pro-rata daily basis (to the extent that they are not treated as non-assessable non-exempt income):

31 March 2015;

31 March 2016; and

31 March 2017?

Summary

The business interruption compensation payment cannot be apportioned to future years as:

● the case is distinguishable from Arthur Murray in that there is no underlying obligation or contingency of repayment on the payment; and

● the substantially correct reflex in relation to when the income was derived is that it occurs either when the income was received or when the recoverable debt was created, both of which have already occurred.

Detailed reasoning

As per the answer above the business interruption compensation payment has the character of the income it is replacing.

In ATO Interpretative Decision ATO ID 2004/426 Income Tax Assessable Income: derivation of membership fees for website access it was discussed when income was derived. The ATO ID 2004/426 states:

As general rule, it is accepted that the question of when income is derived by a taxpayer, as noted by Gibb J in Brent v. FC of T (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195:

   ... is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which 'is calculated to give a substantially correct reflex of the taxpayer's true income'.

This rule has emerged from Dixon J's observation, in Commissioner of Taxation (South Australia) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108; (1938) 5 ATD 98 that:

   ...the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income. Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form.

This principle was endorsed in, amongst other cases, Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673 (Arthur Murray) and Country Magazine Pty Ltd v. Federal Commissioner of Taxation (1968) 117 CLR 162; 15 ATD 86; (1968) 10 AITR 573 (Country Magazine).

The Arthur Murray case and the timing of when income is derived were discussed in Taxation Ruling TR 2014/1 Income tax: commercial software licensing and hosted agreements: derivation of income from agreements for the right to use proprietary software and provision of related services (TR 2014/1). In TR 2014/1 paragraphs 140 to 142 state:

140. Arthur Murray involved a taxpayer who received amounts in advance for a specified number of dance lessons to be given over a period of time. Whilst students did not have any contractual right to a refund, it was the general practice of the taxpayer to give refunds where not all lessons were taken. The taxpayer's books of account recognised fees as income when the lessons to which the fees related were taught.

141. In Arthur Murray, their Honours relevantly held:

It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient's dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

142. The import of Arthur Murray is that once the contemplated contingencies lapse the amount may in an unqualified sense be retained by the service provider. At this point the amount converts from unearned income to earned income for income tax purposes.

Paragraphs 145 to 150 of TR 2014/1 further explain the Australian Taxation Office's view. They state:

145. A commercial practice in relation to refunds must be evidence-based and not merely an assertion. Evidence may include a demonstrated practice over time or a stated practice in corporate policy documents.

146. It is only in cases where a relevant contingency exists in relation to the unqualified retention of the fee in whole or in part, that deferral may be valid for income tax purposes. Where no relevant contingency exists, the amount is derived when a recoverable debt arises in respect of the contractual fee.

147. The context of the reference to damages in Arthur Murray was to contractual damages for breach. Damages pursuant to consumer protection law, or damages in tort, were not contemplated in Arthur Murray and are not relevant to the question of determining the incidence of derivation of 'unearned income'. Chesire and Fifoot's Law of Contract (9th edition) explains the distinction in the following terms at paragraph 23.8:

Damage in Tort and under s82 of the Trade Practices Act 1974 (Cth) are not awarded as damages for the loss of expected performance. Rather, they are assessed so as to put the claimant in the position that he or she would have occupied had the tort or statutory contravention not been committed (Footnote: Gates v. City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 at 11-12). This reflects a commonly accepted distinction between a cause of action based on a breach of duty imposed by law and a cause of action based on a breach of duty assumed by volition.

148. An exposure to contractual damages will exist where at the end of the licence agreement (or at some other time specified in the contract), the commercial software developer is exposed to a provable cause of action for failure to fully perform on the contract. The awarded compensation in such cases is restitutionary to the extent the contract price relates to the obligations not performed (Chesire and Fifoot's Law of Contract (9th edition) at paragraph 23.9).

Only contractual obligations are to be tested

149. The principle considered in Arthur Murray was:

whether, in the circumstances, it may properly be held that receipt without earning makes income ( Arthur Murray 114 CLR 314 at 317-8 per Barwick CJ, Kitto and Taylor JJ).

150. The context was whether income received for contractual obligations yet to be performed were income.

In the timing of when income is derived it is important to consider 'contingency of payment' noted in TR 2014/1. Paragraphs 5 and 6 state:

5. Where an amount properly attributable to a contractual obligation is subject to a 'contingency of repayment', the amount is derived for the purposes of section 6-5 of the ITAA 1997 when the obligation is fully performed or the contingency of repayment otherwise lapses.

6. In this Ruling, a 'contingency of repayment' in the event of future non-performance refers to there being either:

(i) a contractual obligation to make a refund;

(ii) a demonstrated commercial practice to make a refund; or

(iii) contractual exposure exists for damages in respect of the non-performance.

Contingency of payment is further discussed in paragraphs 8 to 10, which state:

8. When the underlying obligation is fully performed, or the contingency of repayment otherwise lapses, the amount properly allocated to the obligation converts from 'unearned' income' to 'earned income' in the sense contemplated in Arthur Murray (NSW) Pty Ltd v. FCT (1965) 114 CLR 314; (1965) 14 ATD 98; 9 AITR 673 ( Arthur Murray ).

9. Where no 'contingency of repayment' exists, the amount is derived when a recoverable debt arises in respect of the contractual fee.

10. Potential exposure to:

● damages pursuant to consumer protection law; or

● damages in tort;

do not result in there being a 'contingency of repayment'.

The Entity's situation in this instance is distinguishable from the Arthur Murray case as in this instance there is no underlying obligation or contingency of repayment. The business interruption compensation payout has been made and was not made contingent to possible repayments.

While the insurance payout was made based on the predicted income of the Entity, the payment has not been made to take into account any contingencies. For instance if the Entity's premises were built in a timelier manner than that supposed by the insurance company the Entity would not have to pay back any of the business interruption payment.

Cash or accruals method

In Taxation Ruling TR 98/1 Income tax: determination of income; receipts verses earnings (TR 98/1) provides guidance on the appropriate method of determining when income is earned in one year of tax but received in another.

Paragraph 8 to 10 of TR 98/1 gives the definitions for the receipts or cash methods and the earnings or accruals method.

Receipts method

8. The 'receipts' method is sometimes called the 'cash received' basis or the 'cash' basis. Under the receipts method, income is derived when it is received, either actually or constructively, under subsection 6-5(4) of the ITAA 1997. The effect of that subsection is that income is taken to have been derived by a person although it is not actually paid over, but is dealt with on his/her behalf or as he/she directs.

Earnings method

9. The 'earnings' method is often referred to as the 'accruals' method or the 'cash and credit' method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.

10. The term 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task. A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt.

11. Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions.

In paragraph 26 of TR 98/1 it is noted that:

For many taxpayers the income they derive in a year is the income received in that year: Brent v. FC of T. For other taxpayers the income they derive in a year is the income earned in that year: Henderson's case.

When a taxpayer is considering which of the two methods is the most appropriate they

…must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives a 'substantially correct reflex' of that income. This is the principle established in Carden's case.

28. Whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden's case, to:

...discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.

29. Appropriateness of the accounting method used by a taxpayer is the sole test for determining which method of accounting should be used: Henderson's case; Brent's case; and Barratt's case.

30. Only one method of accounting is appropriate to any one item of income; there is no choice available.

In this circumstance, if the receipts or cash method is used, the business interruption compensation payout would be considered to be derived when the income was actually received. The business interruption compensation payout was received by the Entity in the income tax year ending 20XX.

If the earning or accruals method was used the business interruption compensation payout would be considered to be derived when a recoverable debt is created. A recoverable debt in the circumstances was created when the insurance company agreed to pay out the business interruption compensation payout as per the contractual obligation. Considering that the business interruption compensation payout has already been received it is understood that the recoverable debt has already been created.

Both of the methods determine that the payment should be included in the income year and should not be apportioned. While the business interruption compensation payout was intended to compensate the Entity for income it would have derived over a specific period it would not be a substantially correct reflex to apportion the income forward as the Entity already has the benefit of the income.

Conclusion

In conclusion, the business interruption compensation payment cannot be apportioned to future years as:

● the case is distinguishable from Arthur Murray in that there is no underlying obligation or contingency of repayment on the payment; and

● the substantially correct reflex in relation to when the income was derived is that it occurs either when the income was received or when the recoverable debt was created, both of which have already occurred.