Edited version of private advice

Authorisation Number: 1051967479297

Date of advice: 20 April 2022

Ruling

Subject: Lump sum - ex-gratia payment

Question

Is the ex-gratia settlement payment received from your previous employer included in your taxable income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You ceased permanent full-time employment.

Following the cessation of your employment, you issued correspondence to your former employer in claim of unpaid wages due to underpayment of overtime, time-in-lieu and incorrect pay rates.

Your former employer responded with correspondence that they deny any underpayment of wages owed to you.

Your former employer issued correspondence outlining a settlement offer to settle the claim.

You responded with a counteroffer that was accepted by your former employer.

More than 12 months after your employment ceased, a Deed of Release and Settlement between you and your former employer was signed.

The Deed of Release and Settlement states that without any admission of liability, the parties have agreed to settle any claims arising out of the employment and underpayment claim.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-25

Reasons for decision

Ordinary Income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources 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.

Payments of salary and wages are income according to ordinary concepts and are included in your assessable income.

Taxation Determination TD 93/58 outlines the circumstances under which the receipt of a lump sum compensation/settlement payment is assessable as ordinary income.

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).

The lump sum payment has not been paid to you as compensation for lost salary and wages. Therefore, the lump sum payment is not ordinary income and is not assessable under subsection 6-5(2) of the ITAA 1997.

Capital gains

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income and are also included in assessable income.

Amounts received as a lump sum are generally capital in nature and are potentially taxable as statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

Part 3-1 of the ITAA 1997 contains the capital gains and capital loss provisions commonly referred to as the CGT provisions. You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the capital gains tax implications for compensation receipts. Paragraph 70 of TR 95/35 provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt.

The 'look-through' approach is defined in paragraph 3 of TR 95/35 to be the process of identifying the most relevant asset. It requires an analysis of all the possible assets of the taxpayer to determine the asset to which the compensation amount is most directly related. It is also referred to as the underlying asset approach.

Section 104-25 provides that CGT event C2 happens on the ending of the right to seek compensation, that is, the right to take legal action.

You have entered into an agreement to accept a lump sum payment to settle any claims arising from your employment and the underpayment claim. Thus, the relevant asset is the right to seek compensation. It is considered the lump sum amount you will receive is a payment for the ending of this right. Therefore, CGT event C2 happened on the signing of the deed and a capital gain may arise.

If the capital proceeds from the CGT event (that is, the lump sum payment) is more than the costs associated with that event, you will make a capital gain and this forms part of your taxable income.