The Full Federal Court case of Sladden v Commissioner of Taxation [2024] FCAFC 122 (“Sladden” not “Sladen”!) highlights that determining the income tax treatment of settlement payments received under an agreement depends on the circumstances surrounding the entering into of the agreement, not just the terms of the agreement in isolation.
Why do we care?
Generally, settlement or compensation payments adopt the income tax character of the loss that is being compensated.
For example, if a person receives compensation for unpaid wages, the compensation is assessable to that person as ordinary income. That is, the compensation is on revenue account.
Conversely, if a person receives compensation for loss or injury sustained in their occupation, the compensation for that loss or injury is generally on capital account. Section 118-37 of the Income Tax Assessment Act 1997 (ITAA97) then disregards any capital gain or capital loss resulting from that compensation.
If a settlement payment pertains to multiple heads of claim which have not or cannot be reasonably ascertained or estimated (i.e. an “undissected lump sum”), then generally the entire settlement payment is treated on capital account as capital proceeds from the ending of the taxpayer’s right to seek compensation under CGT event C2 (to which the capital gains tax (CGT) discount may be available). See McLaurin v FCT [1961] HCA 9 and Allsop v FCT (1965) [1965] HCA 48.
However, whether a receipt is characterised as an undissected lump sum in the hands of the recipient is not necessarily determined exclusively by reference to the terms of settlement but requires an examination of the entirety of the facts and circumstances surrounding the agreement. See FCT v Spedley Securities Ltd (1988) 19 ATR 938.
Unsurprisingly, taxpayers favour capital account treatment.
What happened in Sladden?
Dr Sladden (the Taxpayer) held two linked insurance policies, one for income protection and one for life cover.
In 2013 the Taxpayer made a claim under the income protection policy and from that time had been receiving regular payments under that policy. The Taxpayer later sought a commutation of her income protection insurance benefit. The insurer offered her $1 million in full and final settlement of her request, which was accepted by the Taxpayer pending formalisation under a deed of release.
While the terms of the deed of release were being drafted by the insurer, the Taxpayer sought advice that confirmed that income protection lump sums are generally taxed on revenue account, whereas life insurance lump sums are generally taxed on capital account (and potentially tax free pursuant to section 118-300 of the ITAA 97).
The Taxpayer requested amendments to the draft deed of release so that the deed acknowledged that the policy that she was surrendering in exchange for the settlement sum was not exclusively in respect of income protection, but also life cover (which was broadly accepted and reflected in the final deed of release that was executed). At that time, the sum insured payable on death or trauma under the life policy was $27,471.96.
Despite the deed of release, the Australian Taxation Office (ATO) assessed the Taxpayer on the basis that the entire settlement sum of $1,000,000 was assessable on revenue account, whereas the Taxpayer argued that the settlement sum was an undissected lump sum assessable on capital account.
What did the court decide?
The Administrative Appeals Tribunal (and then the Full Federal Court) agreed with the ATO having regard to the facts and circumstances surrounding the entering into of the deed of release.
In this case:
The discussions between the Taxpayer and the insurer revealed that, when the Taxpayer expressed her willingness to accept the insurer’s offer of $1,000,000, this settlement sum was expressly in respect of what the insurer would pay for the commutation of the Taxpayer’s income protection benefits (not in respect of her life cover).
It was only later, when the deed of release was being drafted and after the provision of tax advice, that the Taxpayer turned her mind to the life cover aspects of the policy which she was agreeing to surrender.
Despite the Taxpayer agreeing under the deed of release to surrender the life cover, the settlement sum remained $1 million (the same amount offered by the insurer to commute her income protection benefit); and
before entering into the deed the Taxpayer engaged an actuary to value her income protection benefits for the purpose of assessing the insurer’s offer of $1 million, but did not take similar steps to value the life cover.
Accordingly, it was considered that in light of the surrounding facts and circumstances there was “an air of unreality and artificiality” about the Taxpayer’s contention that there was a capital element involved in her settlement payment.
Key principles from the case
The Full Federal Court (having regard to established case law) stressed the following:
In characterising payments made under an agreement, the terms of the agreement must be examined but so too must the whole of the circumstances surrounding its execution, its operation, and the receipt of the money in question (see paragraph 49). However, the character of the receipt is not to be determined by reference to the uncommunicated subjective state of mind of either party (see paragraph 56).
The surrounding circumstances include the objective facts and the circumstances known to both parties. However, the surrounding circumstances do not extend to uncommunicated reasoning which led the payer to agree to pay it or to the payee agreeing to accept it (see paragraph 50).
Where the surrounding circumstances support the existence of multiple causes of action for unliquidated damages. a lump sum of damages accepted in full satisfaction of the entirety of the taxpayer’s claims may be characterised as an undissected lump sum (see paragraph 50).
The nature of a sum received pursuant to an agreement is not determined by reference to the surrounding circumstances to the exclusion of the terms of the agreement. Where a payment is made pursuant to an agreement that is not a sham, the “why and how” of the payment is determined according to the terms of the agreement (see paragraph 51).
And the lessons for us?
While the outcome for the Taxpayer – revenue account treatment - is unsurprising, the case highlights:
the benefits of robust and detailed discussions between parties prior to the formalisation and execution of an agreement that results in the payment of a settlement sum; and
the benefits of a written agreement that encapsulates the bargain reached between the parties and the conditions underpinning the payment of a settlement sum.
Anything else?
You or your clients may receive settlement payments or compensation in a range of circumstances.
For instance:
A party seeking to sue a third party for a contractual breach, or breaches, may agree to receive an amount as full and final settlement for any claim or action brought.
Employees may file claims against employers for issues like wrongful termination, harassment, or discrimination, seeking compensation for emotional distress, lost income, or legal fees.
A landowner may receive compensation for nuisance and (e.g. noise and shadow flicker from a neighbouring wind farm) or for the permanent damage (or reduction in value) of their land.
The questions that may require careful consideration are:
For what is the compensation or settlement amount being paid (and noting subtle differences can alter the tax characterisation)?
For example, the ATO views on the taxation treatment of payments for easements differ depending on whether the landowner receives the payment for granting the easement (Taxation Determination TD 2018/15) or in respect of an easement created by statute in favour of a public authority (Taxation Ruling 97/3).
Does the compensation or settlement amount pertain to multiple heads of claim?
If there are multiple heads of claim, are they all on revenue or capital account?
Could the compensation, or part of, be statutory income, outside the CGT rules, such as an eligible termination payment?
Will the settlement sum be undissected, or reasonably ascertained or estimated between revenue (e.g. lost earnings) and capital (e.g. loss of income earning capacity)?
Do the terms of the settlement deed align with the discussions between the parties?
Have the parties considered the ATO’s views in Taxation Ruling TR 95/35 (concerning the “look-through approach”) and Taxation Determination TD 93/58 that discuss compensation payments?
With respect to the “look-through approach” in TR 95/35, the ATO says “it is often appropriate to adopt a 'look-through' approach to the transaction or arrangement which generates the compensation receipt. We regard this concept as the most appropriate basis on which to determine whether any capital gain arises on the disposal of any asset of the taxpayer”.
This approach appears consistent with the approach of the court in Sladden so we would not expect any changes to the ATO views in TR 95/35.
Have the parties considered the goods and services tax (GST) consequences of the settlement payment (the ATO views on GST and settlement payments are in GST Ruling GSTR 2001/4)?
In GSTR 2001/4, to determine the GST characteristics of a settlement payment, the ATO says “[i]n determining whether a sufficient nexus exists between supply and consideration, regard needs to be had to the true character of the transaction. An arrangement between parties will be characterised not merely by the description which parties give to the arrangement, but by looking at all of the transactions entered into and the circumstances in which the transactions are made”.
Again, the ATO’s approach, albeit it a different context, appears consistent with the approach of the court in Sladden.
Sladen Legal has assisted many clients with settling compensation payments and drafting terms of settlement.
Please contact us if you have any questions.
Edward Hennebry
Senior Associate
T +61 3 9611 0113 | M +61 428 439 730
E ehennebry@sladen.com.au
Neil Brydges
Principal | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au
Kaitilin Lowdon
Principal Lawyer
M +61 402 859 214 | T+61 3 9611 0120
E: klowdon@sladen.com.au
Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 | T +61 3 9611 0105
E: dsmedley@sladen.com.au
Rob Warnock
Principal Lawyer
T +61 3 9611 0155 | M +61 419 892 115
E: rwarnock@sladen.com.au
