Private ruling: Lump sum payment
Published: March 2014
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is the lump sum payment received under the income protection policy assessable as ordinary income? | A1: Yes.


Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 6-5(2) Detailed reasoning | Lump sum payment | Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year. | Based on case law, it can be said that ordinary income generally includes receipts that: | n are earned, | n are expected, | n are relied upon, and | n have an element of periodicity, recurrence or regularity. | Payments of salary and wages are income according to ordinary concepts and are included in assessable income under section 6-5 of the ITAA 1997. | 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). | Therefore periodic payments received during a period of total or partial disability under an income protection policy are assessable on the same principle as salary and wages. This is because the benefits are a replacement of employment income during the period of total or partial disability ( FC of T v. D.P. Smith 81 ATC 4114; (1981)11 ATR 538). | Although a lump sum payment under an income protection policy is not a periodic payment, the above principle may also apply to a lump sum paid to settle all outstanding claims under the policy. To determine the character of such a lump sum, it is necessary to consider the terms of the particular policy and the reason for making the payment. | The issue of whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability was considered in Coward v. FC of T 99 ATC 2166; (1999) 41 ATR 1138. In that case Mathews J found that payments made to replace income take on the character of the payment they replace and that the method of payment does not alter the character of the payment. Mathews J held that as the weekly compensation payments made to the appellant until he turned 65 were paid for loss of earnings and thus constituted income, a lump sum representing redemption of those future weekly payments was also income. | This is consistent with the approach taken by the Commissioner in Taxation Determination TD 93/3 which deals with the partial commutation of periodic payments to a lump sum. As outlined in paragraph 4 of TD 93/3, such a commutation would result in the lump sum remaining assessable, as its effect was simply to pay in advance the future weekly payments. | This view has also been confirmed in Sommer v FC of T 2002 ATC 4815; 51 ATR 102 ( Sommer's case) . The case involved a medical practitioner who had taken out an income protection policy. Following the rejection of the taxpayers claim for income replacement payments of $4,000 per month, the matter was settled out of court with the taxpayer receiving a lump sum. | The taxpayer argued that the amount was a payment of capital as it was paid in the consideration of the cancellation of the policy, and the surrender of his rights under it or that the payment was capital as it was an un-dissected aggregation of both income and capital. | In dismissing the taxpayers appeal it was held that the payment was in settlement of income claims of the taxpayer in circumstances where the purpose of the insurance policy was to fill the place of a revenue receipt. As a result, the payment was clearly on revenue account. The fact that the payment was received in one lump sum did not change its revenue character. | In your case, the income protection policy protects and provides income in the event of illness or disability. The regular payments received in relation to this policy replaced lost earnings (salary). The purpose of the payments was a substitute for the income which would otherwise have been earned. | You were offered a lump sum payment in full settlement of the policy. That is, the future regular payments were commuted to a lump sum. The lump sum was paid to substitute for loss of income which otherwise would have been earned. As the periodic income replacement payments are ordinary income, the lump sum payment also retains the character of being ordinary income. | The fact that some of the money is used to pay your medical expenses does not change the character of the payment. | Consequently, the lump sum payment is assessable under section 6-5 of the ITAA 1997.


Relevant facts: The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are: | n the application for private ruling and | You commenced an income protection claim through your employer's insurer. | In 20XX you accepted a settlement offer from your employer as you believed your health would prevent you from returning to your normal role. | Part of the settlement agreement involved ongoing payments in relation to your income protection claim for the duration of your illness, up to the end of the coverage period of two years if necessary. | In 20YY the insurer, based on medical advice received, offered a pay-out amount in exchange for a signed deed of release. | You accepted this offer as the payment would be used to cover the cost of extensive treatment required and it removed the need for ongoing reviews and possible cessation of payments. | No tax has been deducted from the payment.