Edited version of private advice

Authorisation Number: 1052046581871

Date of advice: 28 October 2022

Ruling

Subject: Settlement payment

Question 1

Is the payment of $XX,XXX you received assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the payment subject to capital gains tax (CGT)?

Answer

Yes.

Question 3

Does the CGT exemption under section 118-305 of the ITAA 1997 apply?

Answer

No.

Question 4

Does the CGT exemption under section 118-300 of the ITAA 1997 apply?

Answer

No.

This ruling applies for the following period:

Years ended 30 June 20XX

The scheme commences on:

XX/XX/20XX

Relevant facts and circumstances

The administrator of Z's superannuation fund ('the fund') mistakenly recorded one of Z's personal details when they joined the fund.

Since that time the administrator sent Z communications advising that they held particular levels of death and total and permanent disablement insurance cover which were incorrect as they were based on the wrong personal details.

When Z passed away, the fund's records showed that Z held death insurance cover under the policy taken out by the fund's trustee for Z as a member, in the sum of $XXX,XXX whereas the correct amount payable under the policy was $X,XXX.

The insurer under the policy paid $X,XXX to the fund's trustee who credited it to Z's account balance with the fund.

The $X,XXX was included in the Death Benefit which was paid to the beneficiaries, being yourself and X other beneficiaries, in equal shares.

You received a PAYG payment summary for your share of the Death Benefit.

In addition to the Death Benefit, the beneficiaries also received a payment by the trustee of $XXX,XXX.

This payment was made by the trustee as a consequence of a complaint made by the beneficiaries to the trustee that the amount of death insurance payable ought to have been the amount of death cover calculated by reference to the personal details error rather than the amount of $X,XXX.

In order to settle the complaint, the trustee agreed to make a payment of $XXX,XXX representing the difference between what the beneficiaries claimed should be the amount of death cover payable and $X,XXX. This payment was to be shared equally between the beneficiaries.

Under the terms of the Deed of Release, the payment of $XXX,XXX was referred to as an 'Ex-Gratia Payment'.

You received your share of the payment being $XX,XXX during the 20XX-XX income year.

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 104-25

Income Tax Assessment Act 1997 section 118-300

Income Tax Assessment Act 1997 section 118-305

Reasons for decision

All legislative references below are to the Income Tax Assessment Act 1997 unless otherwise noted.

Summary

The payment of $XX,XXX you received does not have any characteristics of ordinary income; rather, it is clearly a capital receipt. It was received in return for surrendering your right to seek compensation which was a CGT asset. Consequently, it is subject to CGT unless a CGT exemption applies.

The CGT exemption provided by section 118-305 in relation to superannuation does not apply. Although the compensation amount was for a misleading error that was in the general context of superannuation, it does not have the requisite connection to an amount payable out of a superannuation fund. This is because the error did not change the actual value of your interest in the superannuation fund; this value remained the same whether or not the error occurred. The error misled you as to what the value was but did not result in a change to the real value.

The CGT exemption provided by item 4 of the table in subsection 118-300(1) in relation to an interest in a life insurance policy, does not apply. It is unclear whether you had an interest in X's life insurance policy or merely an interest in the Death Benefit that included the proceeds of the policy. However, even if you did have an interest in the policy itself, the compensation amount did not have a sufficient connection to the policy for the purposes of the exemption under section 118-300 because the error did not change the actual value of the policy, rather it misled you as to what the value of the policy was.

Detailed Reasoning

Ordinary income

Subsection 6-5(2) provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, 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. In Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

Having regard to all of the above, it is clear that the payment of $XX,XXX you received is a capital receipt rather than ordinary income.

Ex-gratia payment

An ex-gratia payment is one that is given as a favour or gift. The term 'gift' is not defined in the Income Tax Assessment Act 1997. Therefore, the word 'gift' takes its ordinary meaning. Rather than attempting to define a 'gift', the courts have described a gift as having the following characteristics and features:

• There is a transfer of the beneficial interest in property
• The transfer is made voluntarily
• The transfer arises by way of benefaction, and
• No material benefit or advantage is received by the giver by way of return.

The cause for the payment in question was the beneficiaries' claim against the trustee. Although the payment was referred to in the Deed of Release as an 'Ex-Gratia Payment', it is considered that the payment is not a true 'gift'. Rather, it was paid to the beneficiaries as compensation to settle their dispute with the trustee.

CGT

Amounts that are not ordinary income but are included in your assessable income by another provision are called statutory income (section 6-10). Statutory income includes net capital gains. Section 102-20 states that a capital gain or capital loss is made only if a CGT event happens. Section 108-5 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property.

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. The relevant CGT asset in your case was the right to seek compensation. The payment you received was in full settlement of the claim made.

Your right to seek compensation was an intangible CGT asset and your ownership of that asset ended when you entered into the agreement to settle the 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 surrendered (subsection 104-25(1)). In your case, the payment of $XX,XXX you received represents capital proceeds for your CGT event C2.

Section 118-305

Section 118-305 provides an exemption to the CGT provisions for amounts that are 'in relation to' a right to all or part of an allowance, annuity or capital amount payable out of a superannuation fund or an asset of the fund. Any capital gain or loss from an amount that falls within that exemption is disregarded.

An individual may receive compensation for an error or a wrong that has a connection to superannuation but is paid from sources outside of superannuation because the payment does not arise under the fund's deed and is not a member benefit. Although the amount has a connection to superannuation it is not a superannuation benefit under Division 307.

The compensation will only be exempt from CGT under section 118-305 if it is 'in relation to' an amount payable out of a superannuation fund.

There are two categories/scenarios into which such compensation may fall:

(1)  The compensation is received for an error or misrepresentation (a wrong) causing the value of the individual's superannuation interest under the fund's deed to be less than it would have been had the wrong not occurred.

Example: The individual and the fund trustee agreed on an investment strategy for their superannuation account that was appropriate given the taxpayer's financial position, risk appetite and goals. However, the trustee mistakenly implemented a different investment strategy and as a result the individual's final superannuation account balance was lower than it would have been if the agreed strategy had been implemented.

(2)  The compensation is received for a wrong but there is no change in the value of the individual's superannuation interest under the fund's deed.

Example: Due to an administrative error by the fund trustee, the superannuation account balance that they had been communicating to the fund member over a number of years had been incorrect.

The phrase 'in relation to' appears frequently in tax and other legislation, and there is a body of case law that has considered this and similar phrases. In a tax context, the phrase 'in relation to' is used multiple times, particularly in Subdivision 118-A which sets out the general exemptions to the CGT provisions.

The case law concludes that although the phrase 'in relation to' has broad meaning, it does not carry the widest possible scope and therefore the context in which it is used needs to be considered to ensure an appropriate breadth of application can be found.

The phrase was considered in Burke v. Federal Commissioner of Taxation [2004] FCA 126 (Burke) in the context of subsection 118-300(1) and whether a CGT event that happened in relation to shares received upon demutualisation of an entity was 'in relation' to a CGT asset being the interest in rights under a life insurance policy on the basis that the taxpayer received the shares because of his life insurance policy. Justice Mansfield concluded that the capital gain on the shares could not be disregarded under subsection 118-300(1), saying:

It is only disregarded if the capital gain resulted from a CGT event (the sale) happening in relation to a ''CGT asset that is your interest in rights under ... a life insurance policy ... in the situations set out in the table''. Relevantly, as noted, the CGT event must happen to the policy of life insurance in respect of the owner. I do not think that the capital gain from the sale happened in relation to a CGT asset that is the interest and rights under the life insurance policy. The interest and rights under the life insurance policy were the same before the sale as after the sale. There has been no CGT event happening in relation to the interest in rights under the life insurance policy. [emphasis added]

With respect to section 118-305, it is considered that an amount of compensation for a wrong that results in the value of a taxpayer's interest in a superannuation fund being less than it would have been had the wrong not occurred has the requisite level of connection with, and is therefore 'in relation to', an amount payable out of a superannuation fund. Therefore, in situations such as Scenario 1, any capital gain arising from the receipt of the compensation would be disregarded under section 118-305.

However, section 118-305 does not apply to situations such as Scenario 2, involving compensation amounts for a wrong that does not result in a change in the value of the recipient's superannuation interest. In these cases, the taxpayer never had an entitlement to any amount other than that represented by their existing interest in the superannuation fund. The compensation amount did not result from a change in the value of their interest in a superannuation fund. In those situations, the compensation sought is for an error that misled the taxpayer which was in the general context of their superannuation interest but does not have the requisite connection to 'a right to an allowance, annuity or capital amount payable out of a superannuation fund'.

The reasoning in Burke supports this conclusion. That case considered the interest and rights under the insurance policy before and after the sale to ascertain whether the requisite connection between the CGT event that happened, and the insurance policy was present. This approach should also be applied in the context of section 118-305 regarding the impact on the value of the taxpayer's interest in the superannuation fund before and after the identification of the wrong. In Scenario 1, the value of the taxpayer's interest in the superannuation fund after the wrong is less than it would have been if the wrong had not occurred. In contrast, in Scenario 2, the taxpayer's superannuation interest is not affected by the wrong, as, even if the wrong had not occurred, the value of the taxpayer's superannuation interest would not have changed.

Your situation falls within Scenario 2 rather than Scenario 1. Therefore, the exemption under section 118-305 does not apply in your case.

Section 118-300

A CGT exemption may be available under section 118-300 for a CGT event happening 'in relation to' a CGT asset that is your interest in rights under a life insurance policy but only in certain specific situations which are listed as items in the table in subsection 118-300(1). Only two situations have any relevance in your case.

The first is Item 3 which applies if you are the original owner of the life insurance policy. As you are not the original owner of the policy, this item does not apply to you.

The second is Item 4 which applies if you are an entity that acquired the interest in the life insurance policy for no consideration. It is unclear whether you had an interest in the actual life insurance policy or alternatively you only had an interest in the Death Benefit which includes the amount of Z's death insurance cover under the policy but not an interest in the policy itself.

In any event, that issue is moot because even if you had an interest in the life insurance policy itself, it is considered that the compensation you received is not 'in relation' to that interest. This is for the same reasons as outlined previously with respect to section 118-305. That is, the actual value of your interest in the policy did not change because of the wrong; rather, the wrong just changed what you thought the value of your interest was.

Consequently, the exemption under section 118-300 does not apply in your case.

Other information

You are entitled to the 50% CGT discount under Division 115 if you acquired your right to seek compensation at least 12 months before the CGT event C2 happened when your ownership of the right ended. The time of a CGT event C2 is when you enter into a contract that results in the asset ending; or if there is no contract, when the asset ends (subsection 104-25(2)).