Private ruling: Income tax - lump sum compensation and interest payment and legal fees
Date of advice: 29 June 2016
Published: August 2016
Ruling period: 1 July 2014 to 30 June 2015

Ruling: Questions and answers | 1. Is the lump sum in arrears compensation payment received from a foreign country included in your assessable income in Australia? | Yes. | 2. Is the interest received on the lump sum in arrears compensation payment included in your assessable income in Australia? | Yes. | 3. Is the lump sum in arrears compensation payment and interest assessable in the year in which it is received? | Yes. | 4. Are you entitled to a foreign tax offset for the any tax paid in relation to the lump sum in arrears compensation payment? | Yes. | 5. Are you entitled to a lump sum in arrears tax offset? | Yes. | 6. Are you entitled to a deduction for legal fees in relation to the lump sum compensation payment? | Yes.

Relevant facts and circumstances: You had an accident on the way home from work. You engaged no win no fee legal representation in Country X to represent you in a claim for backdated compensation payments. Your case was settled out of court. You became an Australian resident for taxation purposes. You received a lump sum in arrears compensation payment for the loss of income, in Country X denomination The amount of $xx.xx in Country X was withheld in pay as you earn tax. You paid legal fees. The legal fees were calculated on the back dated lump sum compensation payment less the pay as you earn tax. The lump sum compensation payment was for the period between xx xx xx and xx xx xx. You received interest on the backdated lump sum compensation payment.. The interest payment covered the same period of time as the lump sum compensation payment. Pay as you earn tax was not withheld from the interest payment.

Relevant legislative provisions: International Tax Agreements Act 1953 | Income Tax Assessment Act 1936 Section 159ZRA | Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 subsection 6-5(1) | Income Tax Assessment Act 1997 Section 770-10 | Income Tax Assessment Act 1997 Section 770-70 | Income Tax Assessment Act 1997 Section 770-75

Reasons for decision: Detailed Reasoning - Double tax agreement: In determining liability to Australian tax on foreign sourced income received by a resident it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreements Act 1953 (Agreements Act). Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and ITAA 1997 so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited provisions). The double tax agreement or convention Country X (the convention) is a section of the Agreements Act. The convention operates to avoid the double taxation of income received by residents of Australia and Country X. An Article of the convention states interest arising in a Contracting state, being interest to which a resident of the other Contracting state is beneficially entitled, may be taxed in that other state. An Article of the convention states that interest may be taxed in the Contracting state in which it arises, and according to the law of that State, but the tax so charged shall not exceed 10 per cent of the gross amount of the interest. The taxation of compensation payments is not mentioned in any of the Articles of the convention; therefore, it is necessary to refer to an Article of the convention which deals with the taxation of items of income that are not specifically mentioned in other Articles of the convention. The Article specifies that items of income of a resident of Australia, not dealt with in other Articles of the convention and arising in Country X, will be taxable in Australia and may also be taxed in Country X. | Detailed Reasoning - Application to your circumstances: Under the convention, Australia has the right to tax the compensation payments and interest payments. The amounts you have received will need to be converted to Australian dollars. | Detailed Reasoning - Compensation and interest payments: Question 1, 2 & 3 Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts. Characteristics of income that have evolved from case law include receipts that: • are earned, • are expected, • are relied upon, • 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. Compensation payments, which substitute income, have been held by the courts to be income under ordinary concepts. The payment retains the characteristics of ordinary income even though paid as a lump sum. Furthermore, where the compensation amount is considered to be income under ordinary concepts, it is assessable on receipt for the purposes of section 6-5 of the ITAA 1997, even though they may relate to a past or future income period (Taxation Ruling TR 98/1). Taxation Determination TD 93/58 considers the assessability of lump sum compensation payments. Paragraph 1 of the ruling states that a payment is assessable where: (a) the payment is compensation for loss of income only e.g. past year profits, and/or interest; or (b) a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature Interest income is normally regarded as ordinary income and therefore forms part of a taxpayer's assessable income. Taxation Ruling TR 98/1 states that the general principle is that interest is only derived, or arises, when it is received or credited. | Detailed Reasoning - Application to your circumstances: You received a lump sum payment which represented the back payment of weekly compensation in relation to income. You also received a lump sum payment of interest in relation to the back dated compensation payment. Accordingly, the lump sum compensation payment and interest you received is assessable in Australia, in the financial year you received it, as it represents ordinary income. | Detailed Reasoning - Foreign Tax Offset: Question 4 If you have paid foreign tax in another country, you may be entitled to an Australian foreign income tax offset, which provides relief from double taxation. Under section 770-10 of the ITAA 1997, to qualify for an offset, you must have paid foreign income tax on an amount that is included in your Australian assessable income for that year. The offset is based on the total foreign income tax paid, however, it is limited to the amount of Australian income tax that would have been payable on the relevant income (sections 770-70 and 770-75 of the ITAA 1997). Before you calculate your net income, you must convert all foreign income deductions and foreign tax paid to Australian dollars. If you are claiming a foreign income tax offset of more than $1,000, you will first need to work out your foreign income tax offset limit. This amount is based on a comparison between your tax liability and the tax liability you would have if certain foreign-taxed and foreign-sourced income and related deductions were disregarded. | Detailed Reasoning - Application to your circumstances: You received a lump sum in arrears compensation payment, for the loss of income in Country X denomination, which you paid tax on. Accordingly, you are entitled to an Australian foreign income tax offset. Note: for further information in relation to claiming a foreign income tax offset please refer to our Guide to foreign income tax offset rules 2014-15 which can be found on our website www.ato.gov.au. | Detailed Reasoning - Lump sum in arrears tax offset: Question 5 Individual taxpayers, who receive certain assessable lump sum payments containing an amount that accrued in earlier income years, may be entitled to a lump sum in arrears tax offset under section 159ZRA of the Income Tax Assessment Act 1936 (ITAA 1936). The tax offset is intended to provide relief on the taxation of the lump sum, as a higher rate of tax may be payable on the lump sum payment in the year of receipt than would have been payable if the payment had been taxed in each of the years in which it accrued. To be eligible for the tax offset, the amount of the eligible lump sum that accrued before the year of receipt must not be less than 10% of the 'normal taxable income' of the year of receipt. To obtain a lump sum in arrears tax offset, the payment must fall within the definition of 'eligible income' for the purposes of section 159ZR of ITAA 1936. The definition of 'eligible income' includes: a) salary or wages to the extent to which they accrued during a period ending more than 12 months before the date on which they are paid; b) salary or wages paid to a person after re-instatement to duty following a period of suspension of the person from duty, to the extent to which the salary or wages accrued during the period of suspension; c) a payment covered by section 12-80 or 12-120 in Schedule 1 to the Taxation Administration Act 1953 ; d) a Commonwealth education or training payment (see subsection 6(1)); e) a payment that is covered by Division 52, 53 or 55 of the Income Tax Assessment Act 1997 , but that is not exempt from income tax under that Division; f) a payment under a law of a foreign country that is similar to a payment covered by paragraph (e); Further section 159ZR of the ITAA 1936 provides the following; rebate year means a year of income for which the conditions in paragraphs 159ZRA(1)(a) and (b) are satisfied; recent accrual year , in relation to the total arrears amount, means: (a) if there are 3 or more accrual years for the total arrears amount - the most recent 2 of those years; or (b) in any other case - the accrual year, or each of the accrual years, for the total arrears amount; | Detailed Reasoning - Application to your circumstances: Paragraphs (b), (c), (d) and (f) are not applicable because they do not relate to workers compensation payments. Paragraph (e) is also not applicable because Divisions 52, 53 and 55 relate to pensions, benefits and allowances under the Social Security Act 1991 or the Veterans' Entitlements Act 1986 and your payment does not fall under any of these Divisions. Therefore, paragraph (a) is applicable; income that is eligible for the tax offset is the salary or wages which accrued during a period ending more than 12 months before the date on which they were paid. Accordingly, you are eligible for the tax offset. However, your lump sum payment covers recent accrual years and distant accrual years which are treated differently; please refer to the below example. | Detailed Reasoning - Example of calculation: During the 2010/11 income year, a taxpayer received a lump sum payment of $10,000 representing a back payment of workers compensation. The lump sum accrued as follows: $1,500 in 2009/10 ('distant accrual' year) $3,200 in 2010/11 $2,800 in 2011/12 ("recent accrual" years) $2,500 in 2012/13 (year of receipt) The taxpayer's taxable incomes were $15,000 in 2009/10, $18,000 in 2010/11, $28,000 in 2011/12 and $65,000 (including the lump sum of $10,000) in 2012/13. Assume that the taxpayer is not entitled to any other offsets for those years. | Detailed Reasoning - Eligibility for offset: The method for determining whether the taxpayer meet the 10% eligibility test for the offset is calculated as follows; (a) Amount of lump sum accrued before year of receipt…… $ 7,500 (b) Taxable income of year of receipt reduced by amount of lump $57,000 sum accrued before year of receipt ($65,000 - $7,500)….. As (a) exceeds 10% of (b), the taxpayer is entitled to the offset. The offset is equal to the amount calculated as: tax on arrears less notional tax on arrears. The steps for calculating the offset are as follows: Step 1: Calculate the tax on arrears Gross tax on 2012/13 taxable income ($65,000).......... $12,672 Less: gross tax on 2012/13 taxable income, excluding amounts that accrued in earlier years (ie tax on $57,000) .......... $10,235 Gross 2012/13 tax attributable to lump sum in arrears .......... $ 2,437 Step 2: Calculate notional tax for recent accrual years 2010/11 year Gross tax at 2010/11 rates on 2008/09 adjusted income ($18,000 + $3,200) .......... $2,280 Less: gross tax on actual 2010/11 income ($18,000) .......... 1 ,800 $480 2011/2012 year Gross tax at 2011/12 rates on 2011/12 adjusted income ($28,000 + $2,800) .......... $3,720 Less: gross tax on actual 2011/12 income ($28,000) .......... 3,300 $420 Notional tax for recent accrual years.......... $900 Step 3: Calculate notional tax for distant accrual year The notional tax for the only distance year (2009/2010) is calculated by multiplying the amount of the arrears which accrued in that year ($1,500.00) by the average rate of tax on the arrears that accrued in the years. The average rate is (rounded to 3 decimal places): (480/3200) + (420/2800) divided by 2 =0.150 Notional tax amount for distant accrual years (1,500 x 0.150)……. $ 225.00 Step 4: Calculation of offset amount Tax on arrears (Step 1) .......... $2,437.00 Less: notional tax on arrears (Step 2 and 3)(ie $900 + $225)....... 1,125.00 Amount of income arrears offset allowable in 2012/13 $1,312.00 Note: for further assistance with calculating the lump sum payment in arrears tax offset please refer to our Lump sum in arrears tax offset calculator on www.ato.gov.au. | Detailed Reasoning - Deductibility of legal expenses: Question 6 Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436 per Dixon J). Legal expenses can be characterised as an outgoing on revenue account or an outgoing of a capital nature. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. Where legal expenses arise as a consequence of the day to day income earning activities, or the purpose of the expenditure is devoted towards a revenue end, the legal expenses are deductible. ( Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible ( Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403). | Detailed Reasoning - Application to your circumstances: You undertook legal action to seek back dated compensation payments for the loss of income. The backdated compensation, for loss of income, is of a revenue nature and it follows that the character of the legal expenses incurred to seek the compensation is also revenue in nature. Accordingly, the legal expenses you incurred are deductible under section 8-1 of the ITAA 1997.