Edited version of private advice

Authorisation Number: 1051586376020

Date of advice: 13 December 2019

Ruling

Subject: Compensation & Employment termination payments

Question 1

Is the proposed ex-gratia payment to be made by your former employer considered to be an employment termination payment (ETP) as defined in section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the proposed ex-gratia payment be included in your assessable income under the capital gains tax (CGT) provisions?

Answer

No.

Question 3

Is the taxable component (if any) of the proposed ETP to be made by your former employer subject to tax?

Answer

Yes.

This ruling applies for the following period

Financial year ending 30 June 2020

The scheme commenced on

1 July 2019

Relevant facts and circumstances

You commenced employment with your former employer in 20XX.

You lodged a claim for compensation in relation to a workplace injury (claim for compensation).

You lodged a further claim for compensation in the same financial year, which related to complications from the treatment of the injury (further claim for compensation).

The former employer issued a determination under the state's workers compensation legislationto reject both claims made by you on the basis that the complication did not arise in the course of your employment with the former employer.

You lodged an application for review in relation to the rejection (workers compensation proceedings).

Subsequently, you and the former employer agreed to settle all matters between you in relation to the claim for compensation, further claim for compensation and/or the workers compensation proceedings, in accordance with the terms of the Deed of Release and Settlement (the Deed).

Your employment was terminated by mutual agreement on the basis that the injury rendered you permanently incapable of working.

Your former employer agrees to make an ex-gratia payment in respect of your personal injury.

Your former employer agrees to make a payment in respect of your entitlements under their enterprise agreement, which amount shall constitute an eligible termination payment, less any amount of income tax required to be withheld.

You release the former employer from any and all claims in relation to the claims made.

The making of the payment fully and finally satisfies any claims of any kind you have or may have had against your former employer in relation to the injury, the claim for compensation, further claims for compensation and/or the workers compensation proceedings.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Division 82

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-37

Income Tax Assessment Act 1997 subparagraph118-37(1)(a)(ii)

Reasons for decision

Summary

The proposed ex-gratia payment to be made to you by your former employer is a capital payment for, or in respect of, personal injury and is specifically excluded under section 82-135 of the ITAA 1997 from being an ETP.

Any tax that would be payable under the CGT provisions will also be disregarded under subparagraph 118-37(1)(a)(ii) of the ITAA 1997.Therefore the amount is not considered to be assessable income you will not be required to include this amount in your income tax return.

The taxable component (if any), of the proposed ETP is assessable income and must be declared in your income tax return for the relevant income year. To the extent that the payment consists of a tax free component, it is not assessable income and is not exempt income.

Detailed reasoning (Questions 1 and 2)

Ordinary income

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997).

Ordinary income has generally been held to include 3 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, and are relied upon, and have an element of periodicity, recurrence or regularity.

Compensation receipts which substitute for income have been held by the courts to be ordinary income; whereas, compensation paid for the loss of a capital asset or amount is regarded as a capital receipt and not ordinary income and is potentially taxable as statutory income.

In your case, the ex-gratia payment is not being made to compensate you for the loss of earnings and it is not earned and does not have any element of periodicity, recurrence or regularity; rather it is a one-off, lump sum amount, being paid for, or in respect of, your personal injury.

The payment is therefore not assessable as ordinary income under section 6-5 of the ITAA 1997.

Statutory income

Your assessable income also includes statutory income amounts which are not ordinary income but are included in your assessable income by another provision of the tax law (section 6-10 of the ITAA 1997).

Section 10-5 of the ITAA 1997 lists those provisions. Included in this list is section 82-10 which deals with ETP's and section 102-5 which deals with capital gains.

Employment termination payment

Division 82 of the ITAA 1997 sets out how ETPs are treated for income tax purposes.

A payment is an employment termination payment if it satisfies all the requirements in section 82-130 of the ITAA 1997 and is not specifically excluded under section 82-135.

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment 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.

Section 82-135 of the ITAA 1997 provides that certain payments are not employer termination payments. Relevantly, these include (among others):

·        unused annual leave or long service leave payments; and

·        reasonable capital payments for, or in respect of, personal injury.

In consequence of termination of employment

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the courts have interpreted the phrase in a number of cases. Whilst the courts have divergent views on the meaning of this phrase, the Commissioner's view on the meaning and application of the 'in consequence of' test are set out in Taxation Ruling TR 2003/13 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of' (TR 2003/13).

While TR 2003/13 contains references to repealed provisions, some of which may have been rewritten, the ruling still has effect as both the former provision under the Income Tax Assessment Act 1936 and the current provision under the ITAA 1997 both use the term 'in consequence of' in the same manner.

In paragraphs 5 and 6 of TR 2003/13 the Commissioner states:

5.... a payment is received by a taxpayer in consequence of the termination of the taxpayer's employment if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been received by the taxpayer.

6. The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is received in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

In this instance, to settle proceedings and all claims lodged by you, you and your former employer agree to settle all matters by entering into a Deed. Further, both parties agree that your employment was terminated by reason of your permanent incapacity for work resulting from personal disability.

Based on the Commissioner's views expressed in TR 2003/13, 'in consequence of the termination' requires that termination be a cause, but not necessarily a dominant cause of a payment.

Although the dominant cause of the payment is to settle the claims initiated by you, there is a causal connection between the termination of the employment and the ex-gratia payment. The ex-gratia payment is the result of a settlement you reached with your former employer in accordance with the provisions of the Deed. It follows that the payment is an effect or result of the cessation of your employment. Clause 4(b)(iv)(C) of the Deed provides that the making of the payments fully and finally satisfies any of the claims you made against your former employer. The claims/proceedings, the termination and the proposed ex-gratia payment are all intertwined and connected. This is further evidenced by the fact that the Deed also contains express clauses dealing with the payment of an ETP in relation to your entitlements under the Enterprise Bargaining Agreement as well as any other accrued statutory entitlements upon termination of your employment with your former employer.

Consequently, the proposed ex-gratia payment is 'in consequence of' the termination of your employment with your former employer.

Payment is received no later than 12 months after termination

Your employment terminated pursuant to the terms of the Deed. Paragraph 82-130(1)(b) of the ITAA 1997 requires that the amount is paid to within 12 months of your termination.

Subsection 82-130(4) of the ITAA 1997 however, provides an exemption from the application of paragraph 82-130(1)(b), (the 12 month rule), if:

·        you are covered by a determination under subsection (5) or (7); or

·        the payment is a genuine redundancy payment or an early retirement scheme payment.

SPR 2007/1 Employment Termination Payments (12 months rule) Determination 2007 provides an exemption where a payment satisfies the requirements of section 82-130 of the ITAA 1997, is not excluded under section 82-135 and legal action was commenced within 12 months of the termination of employment.

Not a payment mentioned in section 82-135 of the ITAA 1997

Section 82-135 of the ITAA 1997 provides that certain payments are not ETPs.

Relevantly, paragraph 82-135(i) states that ETPs do not include:

a capital payment for, or in respect of, personal injury to you so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on your capacity to derive income from personal exertion (within the meaning of the definition of income derived from personal exertion in subsection 6(1) of the Income Tax Assessment Act 1936);

Payments that fall within this exclusion are payments or benefits that compensate or reimburse the person for, or in respect of, the particular injury.

In considering whether the proposed ex-gratia payment falls within the exclusion set out in paragraph 82-135(i) of the ITAA 1997, consideration must turn to whether your has a 'personal injury', what this payment was actually paid for and whether the payment is reasonable having regard to the nature of the personal injury and its likely effect on one's capacity to derive income from personal exertion.

Personal injury

The term 'personal injury' is not defined in the income tax legislation. However, the term has been interpreted by the Administrative Appeals Tribunal (AAT) in several cases.

Flowing from the AAT decisions, it can be said that there are three types of injury a person can receive:

(a)             behavioural injury - one that involves physical injury (internal and/or external) and/or mental injury that is clearly discernible to a qualified medical practitioner;

(b)             non-behavioural injury - hurt, distress, anxiety, et cetera., that flows from the death of, or serious injury to, a relative or close friend; wrongful dismissal; defamation; et cetera. This type of injury may have legal remedies under the law of torts (for example, defamation, slander), statute (for example, sexual harassment, discrimination), or contract (for example, employment, professional negligence); and

(c)             property injury - damage to a person's property.

Notwithstanding it may be said all three types of injury may be personal, it is considered only the first type (that is, behavioural injury) falls within the meaning of the term personal injury.

As per the facts of this case, you made a claim for compensation for an injury. It is quite clear that you suffered a physical injury.

Clause 3(a) of the Deed provides that both parties agree your employment will be terminated by reason of your permanent incapacity for work resulting from personal disability arising from the personal injury.

Clause 4(a)(i) of the Deed provides for the payment of the ex-gratia payment in respect of your personal injury.

It is therefore clear that the proposed ex-gratia payment will be made to compensate you for your particular personal injury. As such, the payment will be made in respect of your behavioural type personal injury. Further, it is considered that the proposed amount is reasonable compensation for the permanently incapacitating personal injury in your circumstances. Hence, the payment is a capital payment for, or in respect of, personal injury.

In view of the above, paragraph 82-135(i) of the ITAA 1997 operates to exclude the entire amount of the proposed ex-gratia payment from being an ETP. Therefore, the requirement under paragraph 82-130(1)(c) is not satisfied.

Consequently, no part of the proposed ex-gratia payment is considered to be an ETP, because the payment is specifically excluded under section 82-135 of the ITAA 1997.

Therefore the amount will not be included in your assessable income under section 82-10 of the ITAA 1997.

Capital gains tax (CGT)

As discussed above the proposed ex-gratia payment will be a capital receipt. Any net capital gain arising from the receipt, worked out in accordance with the CGT provisions of the ITAA 1997 is potentially assessable under section 102-5 of the ITAA 1997 as statutory income.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts deals with the capital gains treatment of compensation receipts. The ruling advocates a 'look-through' approach, which identifies the most relevant asset to which the compensation amount is most directly related. Paragraph 11 of TR 95/35 states that if an amount is not received in respect of an underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

As the proposed ex-gratia payment is not in respect of any underlying asset, the whole of the lump sum payment is treated as capital proceeds from a CGT event (CGT event C2) happening to your right to seek compensation.

You acquired the right to seek compensation when you suffered the injury in 20XX.

Paragraph 108-5(1)(a) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a CGT asset. A taxpayer's right to seek compensation is therefore classified as an intangible CGT asset.

Section 104-25 of the ITAA 1997 discusses CGT event C2 which refers to cancellation, surrender and similar endings. Paragraph 104-25(1)(d) states, in part, that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being surrendered or forfeited.

Subsection 104-25(2) of the ITAA 1997 states that the time of the event is:

(a)   when you enter into the contract which results in the asset ending; or

(b)   if there is no contract when the asset ends.

However, subparagraph 118-37(1)(a)(ii) of the ITAA 1997 disregards a capital gain made from a CGT event relating directly to compensation or damages received for any 'wrong, injury or illness you suffer personally.

Therefore the amount will not be included in your assessable income under section 102-5 of the ITAA 1997, as any capital gain will be disregarded under subparagraph 118-37(1)(a)(ii) and you will not be required to include the amount in your income tax return.

Detailed reasoning (Question 3)

Taxation of employment termination payments

An ETP made may be comprised of the following components:

·        the tax fee component; and

·        the taxable component

Under subsection 82-10(1) of the ITAA 1997 the 'tax free component' of a life benefit termination payment is not assessable income and is not exempt income.

Tax free component is defined in section 82-140 of the ITAA 1997 as so much of the payment as consists of the following:

(a) the invalidity segment of the payment with the meaning of section 82-150 of the ITAA 1997;

(b) the pre-July 83 segment of the payment within the meaning of section 82-155 of the ITAA 1997.

As per section 82-150 of the ITAA 1997 an ETP includes an invalidity segment if:

(a)   the payment was made to a person because they stopped being gainfully employed; and

(b)   the person stopped being gainfully employed because he or she suffered from ill-health (whether physical or mental); and

(c)   the gainful employment stopped before the person's last retirement day; and

(d)   two legally qualified medical practitioners have certified that, because of the ill health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

Taxable component

Pursuant to subsection 82-10(2) of the ITAA 1997 the taxable component of a life benefit ETP is assessable income.

In accordance with section 82-145 of the ITAA 1997, the taxable component of an ETP is the amount of the payment less the tax free component of the payment.

The tax payable on an ETP depends on the age of the recipient when their employment is terminated and the type of ETP received (section 82-10(3)) of the ITAA 1997.

Depending on the type of ETP, the concessional tax treatment may be limited to the smaller of:

·        the ETP cap, or

·        the whole-of-income cap.

If the payment to you contains an invalidity segment, then the ETP cap will apply and the taxable component will be subject to a maximum tax rate of 30% as you are under their preservation age.

If the payment to you does not contain an invalidity segment, the smaller of the two caps applies and the payment is subject to a maximum tax rate of 30% as you are under their preservation age.

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