Edited version of private advice

Authorisation Number: 1051584272709

Date of advice: 23 September 2019

Ruling

Subject: Compensation

Question

Would a payment from entity A be an exempt compensation payment?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Entity A has Division 7A loans to its directors. Entity B and entity C are both shareholders in entity A. There are no other shareholders in entity A.

Entity B first borrowed funds from entity A several years ago.

There were written loan agreements that satisfied the requirements of section 109N of the Income Tax Assessment Act 1936. The required repayments including interest have been made.

As at 30 June 20xx, the closing balance of the directors' loans was $Y. Some loans related to entity C; other loans related to entity B and there were also joint loans.

Entity A directors want to finalise company responsibilities.

Entity B was injured many years ago at work. Another accident occurred some years later. Entity B has had ongoing pain.

Entity A had worker's compensation insurance. Entity B lodged worker's compensation claims and Workcover covered hospital and medical expenses.

No claim was made for loss of time from work as entity B continued doing limited tasks while recuperating.

Entity B was not advised that a claim for pain and suffering could be made to Workcover. Also legal advice said that such a claim would be premature until the full extent and impact of the injury was known. Entity B had not been advised that the time for such a claim has expired. A claim for damages under the Act expired after six years and the opportunity was missed.

Minutes of a Special Meeting of Directors stated that the directors agreed to pay compensation to entity B for pain and suffering when the condition had stabilised and when funds are available. There were reasonable grounds to believe that the company would be able to pay the agreed sum when it falls due - at or before the company is sold or closes down.

The time and amount of compensation was not specified during the meeting as the condition/injury manifestation had not stabilised.

A later director's meeting determined to compensate entity B for pain and suffering and lifestyle compromise. The payment is being made as a moral obligation to compensate the worker who was severely injured at work and continued to serve the company while and after recuperation. The directors see the decision for payment similar to granting a bonus or increase in salary, however this time it is being paid for pain and suffering.

It was agreed to pay entity B a sum, equivalent to the sum of the loans from the directors as a full and final settlement of the matter. No further claims can be made from entity A after the settlement.

Entity A had no funds to pay compensation to entity B, as the cash flow was needed for the business. Entity A is still without substantive funds except loan repayments from directors.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-1

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 118-37

Reasons for decision

Assessable income consists of ordinary income and statutory income. Some ordinary income and some statutory income is exempt income (section 6-1 of the Income Tax Assessment Act 1997 (ITAA 1997)).

Subsection 6-5(2) of the 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.

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 (Inkster's case), 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.

The character of a payment is a question of fact, to be determined on a case by case basis, taking any evidence regarding the payment into account.

In Inkster's case, Pincus J said that, for the purposes of determining whether payments of compensation are assessable income, the essential character and purpose of the compensation provisions must be looked at. However, reading the relevant provisions of the Compensation Act together, it was not possible to accurately say whether the compensation was for loss of earning capacity or as substitution for lost earnings.

Similarly in FCT v Slaven 84 ATC 4086, it was argued, on behalf of the Commissioner, that damages awarded at common law for personal injuries were taxable in so far as they included a component for loss of earning capacity. In our opinion this argument is unsound. Damages for personal injuries may include, as one component, compensation for loss of earning capacity; but this is but one of a number of components of the general award of damages for injuries, even if it is capable of separate quantification. It is not income according to ordinary concepts.

In your case, the amount to be paid to you by entity A is not to compensate you for loss of wages or income and the lump sum payment would not be ordinary assessable income under subsection 6-5(2) of the ITAA 1997.

Amounts received in respect of personal injury are generally capital in nature and are potentially taxable as statutory income under the capital gains tax (CGT) provisions of the ITAA 1997. However, subparagraph 118-37(1)(a)(i) of the ITAA 1997 disregards any capital gain or capital loss made where the amount relates to compensation or damages you receive for any wrong or injury you suffer in your occupation.

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

The exemption under paragraph 118-37(1)(a) of the ITAA 1997 would generally apply in circumstances such as a payment of compensation for personal injuries under a trauma insurance policy and a payment for a workplace injury claim made under the Workplace Injury Rehabilitation and Compensation Act 2013.

In Case 7/2010, 2010 ATC 1-026, a payment that a taxpayer received in settlement for proceedings against his former employer was found not a payment within section 118-37 of the ITAA 1997. The settlement was a single, undissected lump sum with no attribution of any portion of it to any of the various heads of relief claimed by the taxpayer. According to the deed of release, there was no admission of liability by the former employer. Even if the pain and suffering claimed by the taxpayer amounted to personal injury, no part of the payment could represent a payment "for, or in respect of, personal injury".

In your case the following factors are relevant in relation to determining the nature of the payment from entity A:

·         Compensation is generally payable under the Workers' Compensation Act through the employer's insurance.

·         Damages for pain and suffering are generally limited to the limits of the insurance policy.

·         Any obligation to pay compensation is not generally paid at an indefinite time such as when the business is sold or closes or at retirement.

·         The payment is based on what entity A can afford rather than the circumstances surrounding the injury or the extent of the pain and suffering.

·         The payment is being made as a moral obligation.

·         Just because you have pain and suffering does not mean that you are entitled to compensation for pain and suffering.

·         An arm's length obligation to pay an amount of money that relates to previous years generally includes an amount of interest income.

·         The loan balance includes amounts for entity C's loans as well as your loans and joint loans.

·         There is not sufficient evidence to show that the company had a legal obligation to pay you an amount of compensation for pain and suffering.

It is acknowledged that a company can decide what payments are made to an employee. However, the above circumstances do not indicate that the payment from entity A is a genuine arms-length compensation payment. Rather it is a voluntary payment made as a moral obligation. There is not enough evidence to show that any part of the payment to you is for compensation for pain and suffering. The payment is not a result of a compensation claim you lodged. The payment from entity A is not a payment that is in discharge of any legal obligation and is not in the nature of legal damages or compensation. Therefore, the exemption under section 118-37 of the ITAA 1997 does not apply in your circumstances.