Edited version of private advice

Authorisation Number: 1052022784072

Date of advice: 13 September 2022

Ruling

Subject: Compensation payment

Question

Does an amount need to be included as assessable income in relation to the compensation payment received?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You suffered a financial loss due to the negligence of a lawyer that you had engaged.

You made a claim against them and their professional indemnity insurer.

You entered into a settlement deed in which you agreed to settle your claim. You were paid an amount of $X in accordance with the deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 paragraph 118-37(1)(a)

Income Tax Assessment Act 1997 subparagraph 118-37(1)(a)(ii)

Income Tax Assessment Act 1997 Subsection 1-3(2)

Income Tax Assessment Act 1936 Subsection 160ZB(1)

Reasons for decision

Summary

We consider the compensation payment to be capital in nature rather than income in nature. However, the payment is subject to capital gains tax (CGT) and no CGT exemptions apply. Therefore, the resulting net capital gain will need to be included in your assessable income.

Detailed reasoning

Ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Based on case law, it can be said that ordinary income generally includes receipts that are earned, expected, relied upon, and have an element of periodicity, recurrence or regularity.

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? states that a compensation payment will be assessable as ordinary income under the following circumstances:

(a)  if the payment is compensation for loss of income only e.g. past year profits, and/or interest (even when the basis of the calculation of the lump sum cannot be determined); or

(b)  to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature [cf. Mc Laurin v. FC of T (1961) 104 CLR 381; (1961) 8 AITR 180 and Allsop v. FC of T (1965) 113 CLR 341; (1965) 9 AITR 724].

In your case we do not consider that any of the compensation amount is for the loss of income. The entire compensation amount is considered capital in nature. Consequently, none of the compensation amount is assessable as ordinary income under section 6-5 of the ITAA 1997.

Capital Gains Tax (CGT) considerations

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

What generated your compensation receipt are the negligent actions of your lawyer. The relevant CGT asset in your case is the right to seek compensation. The payment received was in full settlement of the claims made.

Your right to seek compensation is an intangible CGT asset (acquired at the time the right arose to take action against your solicitor for their negligence which is when you suffered a loss from their negligence) and your ownership of that asset ended when you accepted the lump sum to settle your claim. 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 event C2.

CGT exemptions

The CGT exemption that requires consideration in this case is provided by paragraph 118-37(1)(a) of the ITAA 1997.

Under paragraph 118-37(1)(a) of the ITAA 1997 a capital gain is disregarded if it is 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.

Wrong you suffer personally

Subsection 160ZB(1) of the Income Tax Assessment Act 1936 (ITAA 1936) which was re-written as paragraph 118-37(1)(a) of the ITAA 1997 sheds light on what is meant by a wrong you suffer personally.

Subsection 160ZB(1) of the ITAA 1936 stated:

A capital gain shall not be taken to have accrued to a taxpayer by reason of the taxpayer having obtained a sum by way of compensation or damages for any wrong or injury suffered by the taxpayer to his or her person or in his or her profession or vocation and no such wrong or injury, or proceeding instituted or other act done or transaction entered into by the taxpayer in respect of such a wrong or injury, shall be taken to have resulted in the taxpayer having incurred a capital loss.

Subsection 1-3(2) of the ITAA 1997 states that where the ITAA 1936 'expressed an idea in a particular form of words' and the ITAA 1997 'appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style', the ideas are not be taken to be different just because different forms of words were used.

There is nothing in an Explanatory Memorandum or any other extrinsic material in relation to the remaking of subsection 160ZB(1) of the ITAA 1936 into paragraph 118-37(1)(a) of the ITAA 1997 that indicates that the meaning or effect of the new provision was to be any different to the old provision.

Therefore, it is considered that a wrong suffered personally by a taxpayer means a wrong suffered 'to his or her person'.

The following principles of statutory interpretation are also relevant in considering the meaning of a wrong suffered personally:

•         The noscitur a sociis rule states that a meaning of a word is derived from its context. For example, in the expression 'house, office, room or place' the word 'place' does not include a public lane.

•         The ejusdem generis rule states that general matters are constrained by reference to specific matters. For example, 'a railway, road, pipeline or other facility' does not include a storage facility (Canwan Coals Pty Ltd v. Federal Commissioner of Taxation (1974) 1 NSWLR 728).

Negligence is a tort so is a legal wrong. It is a failure to take reasonable care to avoid causing injury or loss to another person.

Therefore, it could be argued that the negligence by your lawyer was a wrong that you suffered personally.

However, the meaning of 'wrong' must be considered in the context of the words around it which are 'injury' and 'illness' in relation to paragraph 118-37(1)(a) of the ITAA 1997 and 'injury suffered by the taxpayer to his or her person' in relation to subsection 160ZB(1) of the ITAA 1936.

Taking into account this context, it is considered a wrong suffered personally for the purposes of paragraph 118-37(1)(a) of the ITAA 1997 would include, for example, defamation, as this is a wrong suffered by the taxpayer to his or her person but would not include negligence that causes financial loss as unlike defamation, injury or illness, it is not a wrong suffered by a taxpayer to his or her person.

This interpretation is supported by TR 95/35 which contains two examples that deal with compensation for negligence that resulted in financial loss (examples 8 and 28). In example 8, the taxpayer was assessed on the compensation as a capital gain on the disposal of their right to seek compensation and no CGT exemptions (including subsection 160ZB(1) of the ITAA 1936 or paragraph 118-37(1)(a) of the ITAA 1997) were considered to apply.

In example 28 at paragraph 333 of TR 95/35, the end result was that there was no capital gain but this was because of reasons other than the wrong suffered personally exemption provided for by subsection 160ZB(1) of the ITAA 1936/paragraph 118-37(1)(a) of the ITAA 1997. In that example it states that if any amount of the compensation had been for inconvenience or personal suffering then that amount would be exempt from CGT under the wrong suffered personally exemption. However, as the whole amount of the compensation was for a financial loss caused by negligence the wrong suffered personally exemption did not apply.

Therefore, it is not considered that the negligence by your lawyer that caused you financial loss is a wrong you suffered personally for the purposes of exemption under subparagraph 118-37(1)(a)(ii) of the ITAA 1997, so any capital gain or loss will need to be reported in the appropriate income year.

Calculation of capital gain

The compensation payment is the capital proceeds you received from CGT event C2 on the disposal of your right to seek compensation. The additional expenses you incurred that resulted in your right to seek compensation form part of the cost base of that right for the calculation of the net capital gain. You will also be eligible for the general 50% CGT discount as you are an Australian resident and held the right to seek compensation for more than 12 months.