Edited version of private advice

Authorisation Number: 1051616628860

Date of advice: 6 December 2019

Ruling

Subject: Income tax - lump sum payment

Question 1

Is the lump sum payment regarded as ordinary assessable income?

Answer

No.

Question 2

Is the lump sum payment assessable under the capital gains tax (CGT) provisions?

Answer

Yes.

This ruling applies for the following period

Year ending 30 June 2019

The scheme commenced on

1 July 2018

Relevant facts and circumstances

You commenced casual employment with entity A a few years ago.

You were involved in an unprovoked assault in xxxx and as a result acquired significant injury. At the time of the assault you were still working as a casual employee with entity A.

As your injury was so severe, you were unable to work.

You were granted a disability pension from Centrelink. This pension is now your main source of income.

Entity B engaged lawyers on your behalf to lodge a total and permanent disability (TPD) claim to your employer's superfund. The TPD claim was for your injury, seizures, depression, PTSD and left side weakness.

The insurer rejected the claim because as a casual employee, you did not meet the relevant criteria of TPD definition under the policy.

Without admission of liability, the insurer paid an ex-gratia payment to settle all matters relating to the claim.

The lawyers forwarded the lump sum in xxxx.

You incurred legal costs in relation to the above.

The insurer advised that the full payment was out of goodwill and that no amount represents an interest component.

Under the Deed of Release, you released, discharged and indemnified the insurer and other parties from all obligations arising out of or relating to your rights under the policy and the claim.

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.

In your case, the lump sum payment received was not earned by you as it does not relate to services performed. The payment is not a payment for lost income. The payment is 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 TPD claim lodged.

Therefore 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 TPD claim lodged following the assault. 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 lump sum payment. 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 lump sum payment represents capital proceeds for your CGT C2 event. The cost base will include your legal fees incurred.

CGT exemption

Under paragraph 118-37(1)(a) of the ITAA 1997 a capital gain or capital loss you make from a CGT event is disregarded if it relates directly to 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 paragraph 118-37(1)(a) of the ITAA 1997.

However, the application of section 118-37 of the ITAA 1997 in relation to settling other types of insurance and in circumstances involving 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 (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 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 or wrong suffered as such.

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 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 settlement is not regarded as an income replacement and was paid by the insurer following your TPD claim.

In settlement, you received an un-dissected lump sum payment that was made without admission of liability by your insurer. The payment required you to release the insurer from all obligations under the policy and the claim. Acceptance of the lump sum is considered to be a payment for the ending of your rights under the insurance policy.

Your payment cannot be said to be for a single defined payment for an injury or illness or wrong. In fact it is stated in the Deed of Release that the payment is an ex-gratia payment.

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 you suffered. 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 does not apply.

The settlement sum is considered to be capital in nature and assessable under the capital gains tax provisions as capital proceeds from your right to seek compensation.

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.