Edited version of private advice

Authorisation Number: 1052037766457

Date of advice: 18 October 2022

Ruling

Subject: Capital gains tax - compensation - CGT discount

Question 1

Will the proceeds received as settlement of the 'cross insurance' policy be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the proceeds received as settlement of the 'cross insurance' policy be subject to the capital gains tax (CGT) provisions?

Answer

Yes.

Question 3

Are you eligible to apply the 50% CGT discount under Division 115 of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 2023

The scheme commences on:

1 July 2022

Relevant facts and circumstances

You jointly own and operate a successful business with business partner A.

The business commenced in 20XX.

In the following year, you and partner A agreed to put in place 'cross insurance' policies for one another, in the event of death and temporary or permanent disability.

You own an insurance policy which identifies insurance held for the risk of your fellow business partner A (the Policy). In the event of Death or Total and Permanent Disability of partner A, a lump sum is covered and payable to you.

On XX/XX/20XX, partner A's medical practitioner issued a document to the effect that partner A is permanently disabled due to a medical illness.

You were notified of this and subsequently prepared a claim application under the Policy held for determination by the insurer's assessor.

It was the intent of the parties that the disabled party's capital interest in the business would be replaced with a capital amount of insurance claim proceeds.

Your claim has been approved.

Assumption

The amount payable to you exceeds the cost base resulting in a capital gain.

The insurance cIaim proceeds will be paid to you within 12 months of partner A being declared totally and permanently disabled due to an illness by their medical practitioner.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 102-5

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 section 115-25

Income Tax Assessment Act 1997 section 118-37

Income Tax Assessment Act 1997 section 118-300

Reasons for decision

Question 1

Section 6-5 of the ITAA 1997 includes income according to ordinary concepts (ordinary income) in assessable income. Income according to ordinary concepts refers to an accepted usage of the word 'income' and income that Courts have determined is ordinary income.

Ordinarily, the receipt of insurance proceeds would not come within the term of ordinary income where the payment has been made in the event of death or for deprivation or impairment of earning capacity: Federal Commissioner of Taxation v. Slaven (1984) 1 FCR 11; 84 ATC 4077; (1984) 15 ATR 242.The exception, however, is where the insurance proceeds have been received to replace lost earnings: Federal Commissioner of Taxation v. DP Smith (1981) 147 CLR 578; 81 ATC 4114; (1981) 11 ATR 538.

Taxation Rulings IT 155 Key man insurance - assessability of proceeds and deductibility of premiumsprovides guidance as to the assessability of premiums paid in respect of life insurance for keyman insurance policies.

Paragraph 4 of IT155 provides that proceeds from life and endowment insurance policies should be treated as non-assessable.

The payment of the lump sum insured under the Policy to you is not to replace lost income of partner A. This proposition is supported by the fact that the amount of the payment has no relationship to the amount of income expected to be lost by partner A due to the illness, as well as your intended use of the proceeds received.

Accordingly, the lump sum is a capital receipt, and not assessable under section 6-5 as ordinary income.

Question 2

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision. Net capital gains are included as assessable income under subsection 102-5(1) of the ITAA 1997.

Section 102-20 of the ITAA 1997 provides that you make a capital gain or loss as a result of a CGT event happening to an asset in which you have an ownership interest.

Under section 108-5 of the ITAA 1997 a CGT asset is any kind of property, or a legal or equitable right that is not property. CGT assets include part of or an interest in property or a legal or equitable right that is not property.

Contractual rights under an insurance policy are legally enforceable rights and therefore a CGT asset according to the definition in subsection 108-5(1) of the ITAA 1997.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expiring. The time of the event is when you enter into the contract that results in the asset ending; or if there is no contract - when the asset ends. You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those proceeds are less than the asset's reduced cost base.

When the insurance company pays the sum insured in satisfaction of your contractual right under the Policy, your ownership of the right will be discharged or satisfied. This discharge or satisfaction of the contractual right will give rise to CGT event C2 pursuant to paragraph 104-25(1)(b) of the ITAA 1997.

Accordingly, the lump sum you receive as settlement of a 'cross insurance' policy will be subject to the CGT provisions.

Question 3

Subdivision 115-A of the ITAA 1997 provides for the conditions for a discount capital gain. Relevantly, the conditions include that the capital gain must be made by an individual, a complying superannuation entity, a trust or a life insurance company. The capital gain must result from a CGT event happening after 11:45am on 21 September 1999 and must not have an indexed cost base. Also, the gain must result from a CGT event happening to an asset that was acquired at least 12 months before the CGT event.

The discount percentage for an amount of a discount capital gain is 50% subject to certain conditions - section 115-100(a) of the ITAA 1997

Taxation ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the CGT implications for compensation receipts.

TR 95/35 states that a right under an insurance policy is an asset, and for the purposes of this Ruling, falls within the definition of a right to seek compensation. This right is acquired by the policy owner when the triggering event of the policy occurs. The payment of the claim by the insurer results in the disposal of the right of the policy owner.

The right to seek compensation was acquired at the time the triggering event of the Policy occurred, being when partner A was advised by the doctor that they were permanently disabled. The asset will be disposed of when the insurance company makes payment of the lump sum.

You expect the payment to be made within 12 months of the triggering event of the Policy. Assuming this is what takes place, the right will have existed for a period of less than 12 months; therefore, you are not entitled to apply the 50% CGT discount to reduce your capital gain.