Private ruling: Annual pension commuted to a lump sum
Date of advice: 22 September 2016
Published: November 2016
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Is your right to a pension a CGT asset? | A1: Yes. | Q2: Did CGT event C2 happen when you entered into the deed of release to receive a lump sum payment in full and final satisfaction of all payments and benefits that would otherwise be payable to you as a pension? | A2: Yes. | Q3: Is the lump sum payment capital proceeds? | A3: Yes. | Q4: Is the lump sum payment that you received included in your assessable income as ordinary income? | A4: Yes. | Q5: Is the lump sum payment a discount capital gain? | A5: Yes. | Q6: Does the anti-overlap provisions contained in, section 118-20 of the ITAA 1997 reduce any capital gain by the amount of that income which has otherwise been assessed to you as ordinary income under section 6-5 of the ITAA 1997? | A6: Yes.

Relevant facts and circumstances: The arrangement that is the subject of the private 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: • the application for a private ruling; • deed of release. A long time ago you became a partner of a firm. More than ten years ago you retired. Following your retirement you were entitled to receive an annual pension payable on a monthly basis ('Pension') and your spouse is entitled to receive an adjusted Pension on your death ('Adjusted Pension). You have been returning your pension income at Net Non-Primary Production income from a Partnership or Trust. You later became a board member of a public company. About three to four years later in the year ended 30 June 20XX, you were entitled to an annual pension of a certain amount. The parties (The firm that pays the pension to you; and yourself and your spouse) have agreed that you will be paid a lump sum payment in full and final satisfaction of all payments and benefits that would otherwise be payable to you and your spouse under your pension. The firm paying you the pension has performed an actuarial calculation to ascertain the lump sum payment that is to be made to you (Calculation) and you and your spouse agree with the Calculation. The deed of release specified that the firm would make a payment of a certain amount (lump sum payment) to you by a certain date and this happened. The firm also paid you a final monthly pension payment for the year ended 30 June 20XX of a certain amount to avoid any doubt regarding your entitlement. After the lump sum payment and final monthly payment was made, this meant that you and your spouse have had no entitlement to receive a pension or an adjusted pension. You and your spouse acknowledged that the lump sum payment is in full and final satisfaction of all claims they you had or may have against the firm in regarding the pension, the adjusted pension and the calculations. You have provided an excel spreadsheet summary of your retirement payments received from the firm on a monthly basis and the commutation amount (lump sum payment). You also provided documents from the firm regarding financial information on how your pension from the firm been calculated.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 6-5(2) | Income Tax Assessment Act 1997 Subsection 118-20 | Income Tax Assessment Act 1997 Subsection 108-5 | Income Tax Assessment Act 1997 Subsection 104-25 | Income Tax Assessment Act 1997 Sub-division 115A

Reasons for decision: Summary: The lump sum payment of a certain amount that you received from the firm as a result of entering into the deed of release had the effect of ending all of your entitlement to receive a pension; and/or for your spouse to receive an adjusted pension in accordance with the firm's provision of a pension. Sometimes more than one rule applies to include an amount in your assessable income. The payment is assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). The CGT provisions also apply because the effect of the deed of release meant that CGT event C2 happened. To avoid double taxation section 118-20 of the ITAA 1997 reduces any capital gain arising from a CGT event by that amount that is otherwise assessable. In your case the discount capital gain is reduced to zero and the amount of ordinary income is the lump sum payment amount. | Detailed Reasoning - Ordinary Income: Periodic pension income payments Subsection 6-5(2) of the 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: • are earned • are expected • are relied upon, and • 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 replacement policy are assessable on the same principle as salary and wages. Lump sum payments 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 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. 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 $4000 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 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 a revenue account. The fact that the payment was received in one lump sum did not change its revenue character. Recent case law, Senior v FC of T 2015 ATC 10-392 has also confirmed that a finalisation payment received as a result of signing a deed of release was a substitute at present value, for a future income stream represented by monthly payments. It was therefore found to be ordinary income within section 6-5 of the ITAA 1997. | Detailed Reasoning - Capital gains: While a payment may be properly characterised as ordinary income, a capital gain may still be made and in answering whether a payment is included in your assessable income, it is appropriate to examine these provisions also. However, it should be immediately noted the anti-overlap provisions contained in section 118-20 of the ITAA 1997 operate generally to reduce any capital gain by the amount of that income which has been otherwise assessed to you as ordinary income under section 6-5 of the ITAA 1997. Part 3-1 of the ITAA 1997 contains the capital gains and capital loss provisions commonly referred to as CGT (capital gains tax). You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset. Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the rights to the Ernst & Young pension. The lump sum amount you receive will be capital proceeds for this CGT event and a capital gain will arise. As your right to a pension has been extinguished in the deed of release and it was acquired on your retirement from the firm, the asset, the right to a pension has been held for greater than 12 months you will be eligible for the CGT general discount. The net capital gain you make is then included in your assessable income under section 102-5 (after being reduced by the aforementioned overlap provisions as required). Underlying asset and Taxation Ruling TR95/35 Where compensation is intended to remedy damage to an asset, taxing of that compensation may prevent the remedy occurring. For example, if you incur $1,000 damage to your car and receive $1,000 in compensation, paying tax on that amount would frustrate the purpose of the compensation. For this reason, it is sometimes necessary to identify the damaged underlying asset that the compensation was intended to remedy, and to consider the capital gains tax consequences of the compensation in relation to that asset. Taxing the compensation for the giving up of an income stream does not create this issue, as the income stream would have itself been taxable. | Detailed Reasoning - Application to your circumstances: Ordinary income In your case, you were entitled to a pension that provided a continuation of a share in the profits from the firm. You were receiving regular payments under the pension, you and your spouse agreed with the firm to accept a lump sum payment to pay out their obligation under the pension. Your situation is similar to Sommer's and Senior's case in that you received an amount in settlement of pension income claims against your retirement pension. In Sommer's and Senior's case it was determined that the payment was revenue despite being paid in a lump sum. Therefore, the lump sum payment you receive will be assessable as ordinary income under section 6-5 of the ITAA 1997. Capital gains In this case, the firm is offering a full and final settlement of your right to a pension. Acceptance of the lump sum will be considered the ending of your rights under the retirement pension. This gives rise to CGT event C2. Therefore the lump sum payment will be assessable as a discount capital gain. However as it has been also determined above that the payment that you will receive is assessable as ordinary income, the anti-overlap provisions in section 118-20 of the ITAA 1997 will operate to reduce the capital gain arising as a result of CGT event C2 by the amount of the income assessed to you under section 6-5 of the ITAA 1997. The combined effect of sections 6-5 of the ITAA 1997 and 118-20 of the ITAA1997 is that the receipt will be assessed as ordinary income and the capital gain will be reduced to nil. Note: In a telephone conversation with the ATO you referred to CGT event E6 as being similar in circumstances in which this lump sum payment has been received, (in that there is a foregoing of a right to a pension for a lump sum). You think therefore that the lump sum payment is assessable as a payment of capital only. CGT event E6 happens if the trustee of a trust disposes of a CGT asset of the trust to a beneficiary to satisfy all or part of the beneficiary's right to trust income. This reasoning cannot be applied in this case; there is no trust- beneficiary relationship.