Private ruling: Taxation of a compensation payment
Date of advice: 18 July 2018
Published: September 2018
Ruling period: Year ending 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Is the Settled Sum received an employment termination payment pursuant to section 82-130 of Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Is the Settled Sum received assessable as ordinary Income under section 6-5 of the ITAA 1997? | A2: No | Q3: Is any capital gain arising from the Settled Sum disregarded under section 118-37 of the ITAA 1997? | A3: No

Relevant facts and circumstances: The Taxpayer was a partner in a partnership (the Partnership). In 20XX, the Taxpayer came into conflict with a work colleague and suffered from physical and emotional injury as a result of these events. The Taxpayer made an internal complaint about the conduct, leading to an investigation. Following the resolution of the investigation, The Taxpayer requested a short period in which to seek legal advice. The Partnership undertook not to take any action until this had occurred. Before the period to take advice had expired, The Taxpayer was served with a notice which required them to exit the partnership. The Taxpayer subsequently sought legal advice. The Taxpayer engaged a legal practitioner, and without prejudice communications commenced between the legal representatives for The Taxpayer and the Partnership. In 20YY the parties agreed on the terms on which The Taxpayer would exit the partnership. The terms of the settlement between the parties are contained in the Deed of Release (the Deed) and include the following: ● The Taxpayer’s partnership entitlements would be paid up until their Retirement Date. ● The Taxpayer would be paid an additional sum of money in satisfaction of all claims made for additional moneys. ● The Taxpayer accepted that the arrangements in this Deed are in full and final settlement of any and all claims arising out of or in connection with being a partner. ● The Partnership accepted that the arrangements in the Deed are in full and final settlement of any and all claims arising from the Taxpayer being a partner. No breakdown of the settlement amount received under the Deed or how that amount was calculated could be provided. No formal statement of claims made in relation to seeking compensation for the physical and emotional injury suffered.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 80-5 | Income Tax Assessment Act 1997 Section 82-130 | Income Tax Assessment Act 1997 Subsection 82-130(1) | Income Tax Assessment Act 1997 Subparagraph 82-130(1)(a)(i) | Income Tax Assessment Act 1997 Paragraph 82-130(1)(b) | Income Tax Assessment Act 1997 Section 82-135 | Income Tax Assessment Act 1997 Section 118-37 | Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision: Summary: The Settled Sum (the Payment) paid to The Taxpayer is not an employment termination payment under section 82-130 of ITAA 1997. The Settled Sum is not ordinary income as per section 6-5 of the ITAA 1997. The Settled Sum is not exempt from taxation under section 118-37 of the ITAA 1997. | Detailed Reasoning - Employment termination payment: By virtue of subsection 995-1(1) of ITAA 1997, employment termination payments are defined in subsection 82-130(1) of the ITAA 1997, which states that a payment is an employment termination payment (ETP) if: (a) it is received by you: (i) in consequence of the termination of your employment; or (ii) after another person's death, in consequence of the termination of the other person's employment; and (b) it is received no later than 12 months after that termination (but see subsection (4)); and (c) it is not a payment mentioned in section 82-135. Therefore, a payment will be an ETP if all the conditions in subsection 82-130 (1) of the ITAA 1997 are satisfied. Failure to satisfy any one of the conditions under subsection 82-130 (1) will result in the payment not being treated as an ETP. No termination of employment In the present case, it is necessary to consider whether the payment received was in consequence of the termination of employment. The Taxpayer terminated their working relationship with the Partnership. As a result of the termination, the Taxpayer engaged in a legal dispute which leads to the settlement, as a result of which The Taxpayer received, inter alia, an ex-gratia payment. It is apparent that the ex-gratia payment was received in consequence of the termination, as there is a sequence of events following the termination which has a relationship and connection which ultimately leads to the payment. What constitutes an employee is not defined in tax legislation, so the word takes its ordinary meaning as handed down by the Courts. The Commissioner has released Taxation Ruling TR 2005/16 which discusses the meaning of an employee that has been developed by the Courts. The ruling provides that the relationship between an employer and employee is a contractual one, and is often referred to as a contract of service. In Rose v. FC of T (1951) 84 CLR 118, it was established that a partnership is not a distinct legal entity from its members. Therefore, partners cannot contract with the partnership. As a result, it is not possible to establish that The Taxpayer was ‘employed’ by the Partnership. The meaning of the term ‘employment’ has been often considered by the Courts in the context of employment termination payments made under section 82-130 of ITAA 1997. Under section 80-5, the term employment includes the holding of an office. Two cases are of assistance in defining the nature of the holder of an office as they both deal with payments made to individuals which arise out of employment like relationships. In FC of T v. Sealy (1987) 87 ATC 5076; (1987) 19 ATR 582 at 286;, which concerned a managing partner of a grazing partnership, Pincus J said: The word 'office' has a range of meanings…In some contexts, it refers to a position of authority in a governmental or other public organisation…It is difficult to think of any reason why the legislature should have intended to confine the concession…to instances in which the terminated position is one of a public character or of any high degree of permanency. Presumably, no one would dispute that the position of managing director of a public company could be regarded as an 'office'. In Grealy v. Federal Commissioner of Taxation (1989 ) 24 FCR 405; 89 ATC 4192 at 4197; (1989) 20 ATR 403 at 408, which concerned a university lecturer, the Full Federal Court held: It has to be conceded that the word is capable of a variety of meanings, and its definition greatly troubled the Court of Appeal in Great Western Railway Company v. Bater [1921] 2 KB 128, especially at pp 138 and 142. The word 'office' usually connotes a position of defined authority in an organisation, such as director of a company or tertiary educational body, president of a club or holder of a position with statutory powers…Holders of professional employments, is not made an office holder merely because his position has a name. The question in this case is whether The Taxpayer is considered to be a holder of an office. As explained by the Courts, the word 'office' usually connotes a position of defined authority in an organisation, such as a director of a company or the president of a club. The holder of a professional employment is not an office holder merely because the position has a name. An office holder's position is more than something which is important or substantial within a company. In this instance, The Taxpayer did not undertake additional duties or positions above their responsibilities as partner which could be considered an ‘office.’ In the circumstances, we do not consider The Taxpayer to be an office holder, as she did not have defined authority with distinct responsibilities within the organisation that engaged their services. Accordingly, The Taxpayer is not an office holder for the purposes of section 80-5 of the ITAA 1997. Therefore, it is considered that the ex-gratia payment would not be received by The Taxpayer in consequence of the termination of their employment with the Partnership as required by subparagraph 82-130(1)(a)(i) of the ITAA 1997. | Detailed Reasoning - Assessability of Compensation Payment: Sections 6-5 and 6-10 of the ITAA 1997 provide that the assessable income of an Australian resident includes ordinary and statutory income (for example, capital gains) derived directly and indirectly from all sources, whether in or out of Australia during the income year. The ITAA 1997 does not provide specific guidance on the meaning of ordinary income. However, a substantial body of case law exists which identifies its likely characteristics. Amounts that are periodic, regular or recurrent and relied upon by the recipient for their regular expenditure are likely to be ordinary income, as are amounts that are the product of any employment of, or services rendered by, the recipient. Further, amounts which compensate for lost income or serve as a substitute for other income are themselves income according to ordinary concepts. A compensation amount generally bears the character of that which it is designed to replace ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 10 ATD 82; (1952) 5 AITR 443; (1952) 10 ATD 82). 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 assessable as ordinary income. Taxation Ruling TR 95/25 - Income tax: capital gains: treatment of compensation receipts provides the Commissioner’s view as to the treatment of compensation payments. TR 95/35 provides that there are several factors that need to be considered in determining the relevant asset of a compensation payment. At paragraph 69 it provides the following: The particular asset in respect of which compensation has been received by the taxpayer may be: 1. an underlying asset (analysed in situations A and B; paragraphs 140 to 152 below); 2. a right to seek compensation (analysed in situation C; paragraphs 153 to 171 below); or 3. a notional asset, in terms of subsection 160M(7) (analysed in situation D; paragraphs 176 to 182 below). If an amount is not received in respect of an underlying asset then the asset you are taken to have disposed of in receiving the compensation payment is your right to seek compensation. As part of the settlement the Deed provides that the Taxpayer received an amount of compensation in excess of their partnership entitlements and in satisfaction of all claims they made for additional money. In acceptance of the Deed they also forwent any and all rights to any future claims against the Partnership for moneys. In the Taxpayer’s circumstances there is no underlying asset to identify; the amount that they received was related to the releasing of their right to seek further compensatory amounts from the Partnership. As such the amount the Taxpayer received will be capital proceeds received in relation to the occurrence of a CGT event C2 and will not be assessable as ordinary income under section 6-5 of the ITAA 1997. The Taxpayer has contended that the amount they received was in compensation for the personal wrong and injury that they suffered and therefore the compensation amount that they received should be disregarded under section 118-37 of the ITAA 1997. TR 95/35 provides the following relation to the exemption for personal wrong or injury with reference to what section 160ZB of the Income Tax Assessment Act 1936 now section 118-37: 19. Compensation received by an individual for any wrong or injury suffered to his or her person or in his or her profession or vocation is exempt from CGT under subsection 160ZB(1). Refer to Examples 14 to 17 in this Ruling. 20. Exemption under subsection 160ZB(1) is available if the taxpayer receives compensation in an undissected lump sum which relates wholly to the personal wrong or injury suffered by the taxpayer. Refer to Example 17 in this Ruling. 21. However, if compensation is received by a taxpayer in a lump sum paid in settlement of a number of claims, including a personal injury claim, and its individual components cannot be determined or reasonably estimated, no part of the compensation can be quantified as relating to the personal injury of the taxpayer. Accordingly, the exemption under subsection 160ZB(1) does not apply to any part of the compensation. Refer to Examples 12 and 13 in this Ruling. Unless the full amount of a lump-sum settlement amount can be identified as being received in satisfaction of a personal wrong or injury that full amount will not be exempt under section 118-37 of the ITAA 1997. Similarly, if no reasonable estimates can be made as to the apportionment of the lump sum to specific claims then no amount is exempt under section 118-37 of the ITAA 1997. The Deed provides what the payment is and what it relates to. The Deed makes no mention of the personal wrong or injury suffered, the Deed makes a general reference to the forgoing of all claims to moneys. As no statement of claims exists and no further breakdown of the moneys received could be provided, no amount of the settlement received can be distinguished as being received for a personal wrong of injury and the exemption under section 118-37 of the ITAA 1997 will not apply.