Private ruling: Treatment of compensation payment
Date of advice: 25 November 2020
Published: January 2021
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 September 20XX

Ruling: Q1: Is the settlement payment that the taxpayer received from legal action against the law firm ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA1997)? | A1: No. | Q2: Does paragraph 118-37(1)(a)(ii) of the ITAA 1997 apply to disregard any capital gain or loss arising from the settlement payment for personal injury? | A2: Yes.

Relevant facts and circumstances: The taxpayer commenced an action against his former legal representative for an alleged mishandling of his personal injuries action in legal proceedings for which the taxpayer was granted a certain amount of damages. Following some negotiation, the taxpayer entered into a settlement deed with his former legal representative in which he was paid a sum of money by way of settlement. The sum of money received by the taxpayer from the settlement was paid to him as a lump sum.

Relevant legislative provisions: Subsection 118-37(1) of the ITAA 1997 | Section 104-25 of the ITAA 1997 | Subparagraph 118-37(1)(a) (ii) of the ITAA 1997 | Section 6-5 of the ITAA 1997 | Taxation Ruling TR 95/35: Income Tax: capital gains: treatment of compensation receipts

Reasons for decision: Summary: The settlement payment that the taxpayer received from legal action against the law firm is not ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), income according to ordinary concepts ('ordinary income') is assessable to a resident taxpayer in the year in which it is derived. 'Ordinary concepts' is not specifically defined in the legislation, but existing judicial authority on the matter has identified various factors relevant to the determination of whether an amount is ordinary income. A payment made in substitution for what would have been income if it had been received will generally also be income: FCT v. Dixon (1952) 86 CLR 540 (the Dixon Case ). Likewise, a payment for services rendered, or derived as the result of some employment relationship can also be viewed as income: Smith v. FCT (1987) 74 ALR 411. According to paragraph 1 of Taxation Determination TD 93/58 a lump sum compensation payment is assessable under section 25(1) of the Income Tax Assessment Act 1936 (now section 6-5 of the ITAA 1997): • if the payment is for loss of income only; or • the extent that a portion of the lump sum is identifiable and quantifiable as income. In this case, the settlement payment received as a lump sum from the taxpayer's previous law firm was in respect of the alleged mishandling of his personal injuries action in the legal proceedings, rather than being in relation to loss of income. On the facts of this case, the amount of the lump sum payment received under the settlement deed for personal injury from the law firm would not be assessable under section 6-5 of the ITAA 1997 and would instead be capital in nature. | Detailed Reasoning - Question 2: Does subparagraph 118-37(1)(a)(ii) of the ITAA 1997 apply to disregard any capital gain or loss arising from the settlement payment in respect to personal injury? | Summary: Subparagraph 118-37(1)(a)(ii) of the ITAA 1997 applies to disregard any capital gain or loss arising from the payment in respect to personal injury. | Detailed Reasoning - Detailed reasoning: Apart from ordinary income which is assessable under section 6-5, section 6-10 provides that assessable income includes amounts made assessable by specific statutory provisions. Section 102-5 provides that capital gains are included in assessable income. Therefore, any net capital gain that taxpayer makes is included in his assessable income, unless it is covered by one of the available exemptions. In establishing whether a capital gain has been incurred, it is necessary to identify the asset involved. Taxation Ruling TR 95/35 directs us to look for an underlying asset when compensation is involved. The relevant CGT asset [1] is the taxpayer's right to seek compensation from the law firm in respect of the alleged mishandling of the personal injuries claim in the legal proceedings. The disposal of this right to compensation pursuant to a settlement deed will trigger CGT event C2 under paragraph 104-25(1)(b) of the ITAA 1997. There is likely to be a capital gain under CGT event C2 as a consequence of receiving the compensation payment pursuant to the settlement deed. | Detailed Reasoning - CGT Exemption for Compensation: Subsection 118-37(1) of the ITAA 1997 provides that capital gains or capital losses are to be disregarded where they arise from a CGT event relating to: (a) 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; Any capital gain or loss arising from the compensation payment paid under the settlement deed in will be disregarded under subparagraph 118-37(1)(a)(ii) as the settlement payment was for the personal injuries the taxpayer sustained as a result of the events explained in the facts provided by the taxpayer. Therefore, no part of the settlement payment will be assessable income in the relevant income year. [1] Refer paragraph 108-5(1)(b) of the ITAA 1997.