Edited version of private advice

Authorisation Number: 1051802924375

Date of advice: 05 February 2021

Ruling

Subject: Income - assessable

Question

Is the settlement sum assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question

Is the settlement sum assessable as a capital gain?

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 left work in late 20VV and, apart from casual employment, have not worked since. You were diagnosed with various illnesses.

Doctors have informed you that you are unlikely to be able to work in future, apart from casual employment from time to time.

In late 20XX your superannuation fund, Superannuation Company A, made a Total and Permanent Disability (TPD) claim on your behalf with the fund's insurer. This claim was denied by the insurer.

In late 20YY you lodged a claim in a Court for the insured benefit, interest and costs. Both your superannuation fund and their insurer were party to these proceedings. Both denied liability for the claims.

In late 20ZZ a settlement was signed by all parties. Under this Release you received a payment of $X in full settlement of the claim. You received $Y after legal fees were deducted from the payment.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 118-37

Reasons for decision

Ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) refers to ordinary income as income 'according to ordinary concepts'. This phrase is not defined under the legislation, but a large body of case law has developed to identify the factors that indicate if an amount is income according to ordinary concepts.

Typical examples of ordinary income include salaries, wages, and proceeds of carrying on a business, rent, interest and dividends. Typical examples of items which are not generally ordinary income include lottery prizes, proceeds from a hobby, loans and gifts.

A lump sum payment can be classed as ordinary income if it has been paid in compensation or settlement for lost salary or wages.

The Commissioner's view on the taxation treatment of a lump sum settlement payment is clarified in Taxation Determination: TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? (TR93/58).

TD 93/58 states that if a payment is compensation for loss of income only, including interest, then it is assessable income.

This payment was not ordinary income because it is not income under ordinary concepts that is, it was not expected or earned, not related to an income producing activity and was in relation to recovery of a private expense.

Accordingly, the lump sum payment is therefore not assessable under section 6-5 of the ITAA 1997.

Capital gains tax

Payments that are capital in nature may be assessable as statutory income under the capital gains tax (CGT) provisions. Your assessable income includes any net capital gains for an income year.

In Taxation Ruling TR 95/35: Income tax: capital gains: treatment of compensation receipts (TR 95/35), the Commissioner states that whether a lump sum or other compensation payment is assessable in the hands of the recipient depends on whether it is a receipt of a capital or income nature. This in turn depends upon consideration of all the circumstances surrounding the payment. It is the character of the receipt in the hands of the recipient that must be determined.

A CGT event C2 happens if a taxpayer's ownership of an intangible CGT asset ends because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. A settlement or compensation payment may be paid as a result of giving up your right to seek compensation and this right is an intangible CGT asset.

However, in TR 95/35 the Commissioner adopts a 'look-through' or 'underlying asset' approach to determine the asset that has been disposed of. The 'look-through' approach is the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related.

Application to your circumstances

The issue to be determined is the character of the lump sum payment in your hands.

•   You left employment due to ill health.

•   Your superannuation fund lodged an application for TPD on your behalf.

•   This application was denied by the insurer.

•   You commenced action in Court seeking payment of your insured benefit, interest and costs.

•   You accepted an offer as full settlement of your claim.

•   A payment of $Y was made to your account after deduction of legal fees.

Having limited documentation which identifies the nature of the payment, the 'look-through' approach leads us to the conclusion that the payment you received was to compensate you for disposing of the right to seek the insured benefit, interest and costs.

In effect, you gave up your right to seek compensation for your claim, and this right is an intangible CGT asset. Therefore, you experienced a Capital Gains Tax (CGT) C2 event i.e. the disposal of the right to seek compensation. The capital proceeds would be the capital payment that you received.

The payment is not assessable as ordinary income as it is not a product of any employment, services or business carried on by you and it does not have the characteristics normally associated with ordinary income, rather, we consider this payment to be a result of your claim for the insurance benefit, interest and costs.

Such a payment is classified as capital. It is not considered to be assessable as income.

The lump sum payment of $X was paid to you to dispose of your right to seek compensation. In return for this payment you discontinued your action against your former superannuation fund and its insurer.

Part 3-1 of the ITAA 1997 contains the general capital gains tax (CGT) provisions. The disposal of an asset gives rise to a CGT event. Paragraph 118-37(1)(a) of the ITAA 1997 disregards payments or receipts for the purposes of the CGT provisions where the amount relates to compensation or damages you received for any wrong, injury or illness suffered in your occupation.

However, the compensation amount of $X does not meet this description as the payment relates to your disposal of a right to seek compensation, not to a wrong, injury or illness you suffered. Paragraph 118-37(1)(a) of the ITAA 1997 will therefore not apply to the compensation amount so that any capital gain or capital loss will be assessable.

The capital gain or capital loss will be the difference between the incidental costs and the compensation received. In this case, that gain will be the net payment of $Y after deduction of the legal costs from your gross payment.

Paragraph 153 of TR 95/35 outlines that the asset, being the right to seek compensation, is acquired at the time of damage, monetary loss or injury occurs. In a personal injury claim, it is generally at the time the personal injury or wrong occurs.

As your injury occurred in 20VV the asset has been held for more than 12 months and, accordingly, a CGT discount would apply.