Private ruling: Income protection lump sum
Published: February 2014
Ruling period: Year ended 30 June 2013
Date scheme commenced: 1 July 2012

Ruling: Q1: Is the lump sum payment that you received to settle the dispute in relation to your income protection policy assessable income? | A1: Yes.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. You took out an income protection insurance policy. The policy provided for payment of monthly income protection benefits in the event of total disability caused by injury or sickness. In mid 20XX, you submitted a Disability Benefits Claim form seeking payment of a benefit on the basis of a medical condition. Payments under the policy were made to you for a period of five months. You commenced proceedings against the insurer by way of a statement of claim filed in the District Court seeking payment of benefits pursuant to the policy after this time. You agreed to a payment as full and final settlement of any claims under the policy. There is no specific calculation or breakdown of each component of the settlement offer.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5. | Income Tax Assessment Act 1997 Subsection 6-5(2). | Income Tax Assessment Act 1997 Section 104-25. | Income Tax Assessment Act 1997 Section 118-37. | Income Tax Assessment Act 1997 Section 118-20.

Reasons for decision: Summary: The lump sum payment you received is assessable as ordinary income or statutory income. Furthermore, the ending of your right to take legal action triggered CGT event C2. However the capital gain will be reduced by the amount of the income assessed to you as ordinary income. The capital gain cannot be otherwise disregarded. *All legislative references contained are to the Income Tax Assessment Act 1997. | Detailed Reasoning - Introduction: Generally, an amount received in relation to an insurance policy for income protection would be assessable either as: · ordinary income under section 6-5 (whether received as regular payments or a lump sum) · statutory income under section 15-30 (where a lump sum insurance payment is paid in lieu of regular, otherwise assessable payments and it is not itself ordinary income) · a capital gain as CGT event C2 will also happen, but any resulting capital gain is disregarded to the extent that it is assessed under another provision (section 118-20). | Detailed Reasoning - Ordinary income: Periodic income protection payments Subsection 6-5(2) 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, expected, 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 your assessable income. 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 included in your assessable income on the same principle as salary and wages. Lump sum payments Whether the redemption or conversion of an entitlement to periodic payments to a lump sum affects assessability as ordinary income 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 view was subsequently 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 taxpayer's 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. | Detailed Reasoning - Statutory income: Section 15-30 operates to include in a taxpayer's assessable income any amount received by way of insurance or indemnity for the loss of an amount if the lost amount would have been included in the taxpayer's assessable income but was not assessable under section 6-5. | 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 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 or statutory income under section 15-30. Part 3-1 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 provides that CGT event C2 happens on the ending of the right to seek compensation, that is, the right to take legal action. The lump sum amount you receive will be capital proceeds for this CGT event and a capital gain will usually arise. 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). CGT Exemption Paragraph 118-37(1) (b) allows a capital gain to be disregarded if it is compensation or damages you receive for any wrong, injury or illness you suffer personally. This provision would have clear and direct application in relation to an insurance policy against a specific injury or illness. For example, trauma insurance that pays a lump sum if the person loses a limb or suffers a heart attack. Such a payment would be disregarded for CGT purposes under 118-37(1)(b). However, the application of 118-37(1)(b) in relation to other types of personal insurance and in circumstances involving the buying out of the policy or the settling of disputes in relation to a policy may be more problematic. In the case of Purvis v. FC of T [2013] AATA 58, the Administrative Appeal Tribunal considered the tax consequences of a Qantas pilot receiving a lump sum insurance payment for the loss of licence. Although the loss of licence came about as a result of illness or injury, the Tribunal found that the payment did not relate directly to compensation or damages within 118-37(1)(b). The amount was calculated without regard to the nature of the personal injury suffered, save that the personal injury had to result in the loss of licence. In cases where a dispute between the insurer and the insured is settled by way of the former making a lump sum payment to the latter. In these circumstances, it would presumably be the case that the payment is intended to compensate the policy holder for the loss of entitlements under the policy and the legal action, rather than to compensate the person for their injury or illness as such. 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. Taxing compensation intended to cover medical benefits, however, may frustrate the purpose of the compensation. In these circumstances it may be appropriate to take a concessional approach and concede that compensation for the payment of medical costs are sufficiently related to personal illness or injury to be exempt from capital gains under paragraph 118-37(1)(b). Taxation Ruling TR 95/35 deals with the issue of compensation and outlines when it may be relevant to consider the compensation in the context of an underlying asset. Primarily the settlement of a dispute involving an income protection policy would amount to the disposal of a right to seek compensation. However, underlying this is the forfeiture of your rights under the contract - predominately, this would involve the right to receive an income stream but there may be subsidiary benefits at issue. If the compensation is received in relation to multiple heads of claim, TR 95/35 allows a reasonable apportionment of that payment. For example, if a payment is intended to replace both an income stream and other potential benefit entitlements, the payment may be apportioned between the two heads of claim on a reasonable basis. However, if the payment is truly an un-dissected lump sum - that is, no reasonable apportionment can be made between the multiple heads of claim - no exemption can be applied unless you are able to prove that the amount received was solely for personal injury. This approach was confirmed in Dibb v Commissioner of Taxation [2004] FCAFC 126 which found that no part of a genuinely un-dissected lump sum could be said to be paid in relation to personal injury. The exemption in paragraph 118-37(1)(b) cannot apply if the compensation amount is received as a lump sum (and that lump sum is truly un-dissected) but there were rights to income type payments as well as rights relating to personal injury that are extinguished in the settlement. | Detailed Reasoning - Application to your circumstances: Ordinary income In your case, you hold an income protection policy primarily designed to protect and provide income in the event of illness or disability. Although there are other benefits potentially payable under the policy, these appear subsidiary in nature and no request was made for payments of such benefits when you lodged your claim with the insurer, nor were such payments part of your legal action. Furthermore, there is no reason to suggest that such secondary benefits would have been claimed in the future. Your situation is similar to Sommer's case in that you received an amount in settlement of income claims against your income protection insurance policy. In Sommer's case it was determined that the payment was revenue despite being paid in a lump sum. Therefore, the lump sum payment you received is assessable as ordinary income under section 6-5. Statutory income Should the Commissioner have erred in characterising the lump sum payment as ordinary income, the payment would be included in your assessable income under section 15-30 as statutory income. Noting that the periodic receipt of income protection payments is considered ordinary income, the payment is an indemnification of the loss that income; and as such, is included in your assessable income. Capital gains In this case, your insurer has offered full and final settlement of any claims under your policy with a lump sum payment. Acceptance of the lump sum is considered to be a payment for the ending of your rights under the insurance policy. This gives rise to CGT event C2. Therefore the lump sum payment is assessable as a capital gain. In relation to whether the settlement payment would be disregarded under paragraph 118-37(1)(b), it is considered that the payment relates primarily, if not solely, to compensate for the loss of your right to an income stream under the policy. The payment is not considered to be solely a payment of compensation for the illness/injury that entitled you to make a claim under the policy. Consequently, it is considered that the capital gain cannot be disregarded under the above provision. Legal costs associated with your action would form part of the cost base for capital gains purposes. A discount of 50% of the gain can also be claimed as the settlement took place more than 12 months after your claim was rejected by the insurer. Further as it has been also determined above that the payment received by you is assessable as ordinary income or statutory income, the anti-overlap provisions in section 118-20 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 either sections 6-5 or 15-30. The combined effect of sections 6-5, 15-30 and 118-20 is that the receipt will be assessed as ordinary income and the capital gain as a result of the CGT event will be reduced to nil. Should we have erred in characterising the lump sum payment as ordinary or statutory income, the payment would nonetheless be assessable as a capital gain under section 102-5 and the exemption under paragraph 118-37(1)(b) would not apply. | Detailed Reasoning - Further information: We note that, generally, legal expenses that have been incurred in pursuing an amount of assessable ordinary income are deductible. However, we have not addressed your eligibility for a deduction for legal expenses in this private ruling. If you require clarification on this matter, please apply for a private binding ruling. With your application you provided a copy of a Private Ruling in relation to another income protection policy payment where the ruling was favourable. The Commissioner issues a ruling on the way in which a tax law would apply to that person in respect of a year of income in relation to an arrangement. You cannot rely on a private ruling issued to another person as their circumstances may vary in some degree from your own.