Private ruling: Assessability of lump sum settlement payment
Published: June 2014
Ruling period: Year ending 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Questions and answers | 1. Is the sum of $X you received in regard to the claim under the Recovery Policy assessable as ordinary or statutory income? | No. | 2. Is the sum of $X you received in regard to the Income Protection Policy assessable as ordinary income? | Yes. | 3. Is the portion of the $X you received in regard to the legal costs of the proceedings in relation to the recovery policy assessable as ordinary or statutory income? | No. | 4. Is the portion of the $X you received in regard to the legal costs of the proceedings in relation to the income protection policy assessable as ordinary income? | Yes. | 5. Are you entitled to a deduction for the portion of the legal expenses you incurred in relation the proceedings in relation to the income protection policy? | Yes.

Relevant facts and circumstances: A number of years ago, you entered into an income protection insurance policy and a recovery protection insurance policy via your insurance broker. Recovery policy Under the terms of the recovery policy: • The insured sum was $X • In the event you became 'totally and permanently disabled', you would receive the insured sum • You paid an annual premium of $X in monthly instalments Income protection insurance contract Under the terms of the income protection insurance policy: • The monthly benefit was $X, subject to X% increases • In the event that you became 'severely disabled' you would receive the monthly benefit until you reached 65 years of age • You paid an annual premium of $X in monthly instalments You initiated proceedings against the insurer and the insurance broker for several claims, including monies owed under the insurance contracts, negligence, breach of contract and breach of statutory duty. The total cost of the legal expenses you incurred in regards to these proceedings was $X. The matter was settled out of court and you signed the deed of release in the relevant income year. In regards to the settlement sum, paragraph 1 of the deed of release states: 1.1 Within 28 days of receiving an original counterpart of this deed signed by … and …, … will pay to … an amount of $X as follows: (a) The sum of $X in regard to the claim under the Recovery Policy; (b) The sum of $X in regard to the Income Protection Policy; and (c) The sum of $X in regard to … legal costs of the Proceedings. ("the Settlement Sum") 1.2 The Settlement Sum is paid in full and final satisfaction and discharge of all claims whatsoever which … or any other person on behalf of … may have against … or … arising out of or in any way connected with the Income Protection Policy, the Recovery Policy, the Proceedings or the Dispute.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 6-5(2). | Income Tax Assessment Act 1997 Section 6-10. | Income Tax Assessment Act 1997 Paragraph 118-37(1)(b).

Reasons for decision: Summary: Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) considers the capital gains tax (CGT) consequences for the recipient of the amount, and whether the amount should be included in the assessable income of the recipient. Compensation includes any amount received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not: in relation to any underlying asset; arising out of Court proceedings; or made up of dissected amounts. In your case, you received a lump sum payment of $X in settlement of your claim. This lump sum amount was dissected in the deed of release into three components, as follows: • $X in regard to the claim under the recovery policy • $X in regard to the income protection policy • $X in regard to your legal costs Therefore, in accordance with TR 95/35, as this is not an undissected lump sum, we need to consider each component separately to determine its assessability. | Detailed Reasoning - $X in regard to the claim under the recovery policy: Under the terms of the recovery policy, in the event you became 'totally and permanently disabled', you would receive a lump sum amount as specified in the contract. Under the terms of the deed of release, you received $X in regard to the claim under the recovery policy. Ordinary income Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources 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 your case, the lump sum payment you received in regard to the claim under the recovery policy was not earned by you as it does not directly relate to services you performed, rather it relates to your loss of physical abilities. The payment is a one-off payment and therefore does not have an element of recurrence or regularity. Although the payment can said to be expected, and perhaps relied upon, this expectation arises from the investment in insurance, rather than from a relationship with services performed. Therefore, the lump sum payment is not ordinary income and is not assessable under subsection 6-5(2) of the ITAA 1997. Statutory income Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income and are also included in assessable income. Amounts received in respect of personal injury which is not for reimbursement of medical expenses, or direct compensation for loss of income will usually be capital in nature and are potentially taxable as statutory income under the capital gains tax provisions of the ITAA 1997. In your case, you received the payment in regard to the claim under the recovery policy, in which a lump sum was to be paid to you in the event you became 'totally and permanently disabled'. Therefore, the most relevant asset is the right to seek compensation under the policy. Paragraph 118-37(1)(b) of the ITAA 1997 states that a capital gain or capital loss you make from a CGT event relating directly to compensation or damages you receive for any wrong, injury or illness you or suffer personally is disregarded. In your case, the recovery policy provided for a lump sum payment in the event you became 'totally and permanently disabled'. Therefore, paragraph 118-37(1)(b) of the ITAA 1997 applies, and any capital gain or capital loss you make in relation to this portion of the settlement sum is disregarded. | Detailed Reasoning - $X in regard to the income protection policy: Under the terms of the income protection insurance policy, in the event that you became 'severely disabled' you would receive the monthly benefit until you reached 65 years of age. Under the terms of the deed of release, you received $X in regard to the income protection policy. Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. The characteristics of ordinary income have already been discussed above. 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). In FTC v. Slaven 84 ATC 4077 ( Slaven's case ), a taxpayer who was injured in a car accident received compensation under the Motor Accidents Act 1973 (Victoria). As a result of amendments made to the Act in 1979 specifically to exclude the payments from tax, the compensation was expressed to be for deprivation or impairment of earning capacity. The compensation was paid to the taxpayer in five irregular instalments which fairly closely approximated her net pre-accident earnings. The essential character of the payments was held to be compensation for the loss or impairment of earning capacity and therefore not taxable. 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 a 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 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income? (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 undissected aggregation of both income and capital. In dismissing the taxpayer's 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 a revenue account. The fact that the payment was received in one lump sum did not change its revenue character. In your case, you claimed monthly benefits under your income protection insurance policy. The nature of an income protection policy is to protect and provide income in the event of illness or disability. The regular payments you previously received therefore were income according to ordinary concepts. The lump sum would be paid to substitute you for your loss of income which you otherwise would have earned, in the same manner as the previous monthly payments you received did. As your periodic income replacement payments are ordinary income, the lump sum payment also retains the character of being ordinary income. Your case is similar to Sommer's case and the lump sum represents a redemption of the right to receive income and is therefore also regarded as income in nature. Accordingly, the $X portion of the settlement sum relating to the income protection policy is assessable under section 6-5 of the ITAA 1997 in the income year in which you received the payment | Detailed Reasoning - $X in regard to your legal costs: The sum listed as being in regard to your legal costs has not been apportioned between the recovery policy and the income protection policy. The Commissioner considers it reasonable to apportion the total legal costs you incurred and total amount you received in regard to your legal costs in accordance with the amounts you received in regard to each policy. Payment for recovery policy legal costs As discussed above, the payment you received in regard to the recovery policy is capital in nature. It follows, therefore, that any legal costs you incurred in regards to the recovery policy, are included in the cost base, and the payment you received for the recovery policy legal costs are included in the capital proceeds. However, as above the capital gain or loss in regard to the recovery policy is disregarded under paragraph 118-37(1)(b) of the ITAA 1997. Payment for income protection policy legal costs As discussed above, the payment you received in regard to the income protection policy is ordinary income in nature. It follows, therefore, that any legal costs you incurred in regards to the income protection policy are deductible, and the payment you received for the income protection policy legal costs are ordinary income. Therefore, you must include $X as ordinary income and you are entitled to include $X as a deduction.