Edited version of private advice

Authorisation Number: 1051777284177

Date of advice: 9 November 2020

Ruling

Subject: Income - assessable - lump sum

Question 1

Are the monthly payments you receive under an income protection policy included in your assessable income?

Answer

Yes.

Question 2

If you receive a lump sum payment instead of the monthly payments, will the lump sum payment be included in your assessable income?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You have paid monthly insurance premiums to an Income Protection insurance scheme.

You were diagnosed with a permanent disability and received monthly benefits from your insurer under the policy.

You have the option to receive a lump sum benefit instead of monthly payments from your insurer.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5(2)

Reasons for decision

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Based on case law, it can be said that ordinary income generally includes receipts that:

•         are earned,

•         are expected,

•         are relied upon, and

•         have an element of periodicity, recurrence or regularity.

Payments of salary and wages are income according to ordinary concepts and are included in assessable income under section 6-5 of the ITAA 1997.

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 according to ordinary concepts (FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

Therefore, periodic payments received during a period of total or partial disability under an income protection policy are assessable on the same principle as salary and wages. This is because the benefits are a replacement of employment income during the period of total or partial disability (FC of T v. D.P. Smith 81 ATC 4114; (1981)11 ATR 538).

Although a lump sum payment under an income protection policy is not a periodic payment, the above principle may also apply to a lump sum paid to settle all outstanding claims under the policy. To determine the character of such a lump sum, it is necessary to consider the terms of the particular policy and the reason for making the payment.

The issue of whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability was considered in Coward v. FC of T 99 ATC 2166; (1999) 41 ATR 1138. In that case Mathews J found that payments made to replace income take on the character of the payment they replace and that the method of payment does not alter the character of the payment. Mathews J held that as the weekly compensation payments made to the appellant until he turned 65 were paid for loss of earnings and thus constituted income, a lump sum representing redemption of those future weekly payments was also income.

This is consistent with the approach taken by the Commissioner in Taxation Determination TD 93/3 which deals with the partial commutation of periodic payments to a lump sum. As outlined in paragraph 4 of TD 93/3, such a commutation would result in the lump sum remaining assessable, as its effect was simply to pay in advance the future weekly payments.

This view has also been confirmed in Sommer v FC of T 2002 ATC 4815; 51 ATR 102 (Sommer's case). The case involved a medical practitioner who had taken out an income protection policy. Following the rejection of the taxpayers claim for income replacement payments of $4,000 per month, the matter was settled out of court with the taxpayer receiving a lump sum.

The taxpayer argued that the amount was a payment of capital as it was paid in the consideration of the cancellation of the policy, and the surrender of his rights under it or that the payment was capital as it was an undissected aggregation of both income and capital.

In dismissing the taxpayer's appeal it was held that the payment was in settlement of income claims of the taxpayer in circumstances where the purpose of the insurance policy was to fill the place of a revenue receipt. As a result, the payment was clearly on revenue account. The fact that the payment was received in one lump sum did not change its revenue character.

In your case, the income protection policy protects and provides income in the event of illness or disability. The regular payments received in relation to this policy replaces lost earnings (salary). The purpose of the payments was a substitute for the income which would otherwise have been earned.

You have the option to accept a lump sum payment in full settlement of the policy. That is, the future regular payments will be commuted to a lump sum. The lump sum will be paid to substitute for loss of income which otherwise would have been earned. As the periodic income replacement payments are ordinary income, the lump sum payment also retains the character of being ordinary income.

Consequently, the monthly payments you receive, and the lump sum payment to replace the monthly payments, are assessable under section 6-5 of the ITAA 1997.